Bamber w Falkena w Llewellyn w Store

2000
FINANCIAL REGULATION
IN SOUTH AFRICA
 Financial Regulation
in South Africa

by

Hans Falkena (Chairman)

Roy Bamber
David Llewellyn
Tim Store

Financial Regulation in South Africa

The information in this publication has been derived from sources which are regarded as accurate and reliable, is of
a general nature only, does not constitute advice and may not be applicable to all circumstances. No responsibility
for any error, omission or loss sustained by any person acting or refraining from acting as a result of this
publication is accepted by the Policy Board for Financial Services and Regulation and/or the authors.

Copyright © 2001 by the authors

All rights reserved. No part of this publication may be

reproduced or transmitted in any form or by any means without
prior written permission from the publisher.

ISBN 1 919835 10 5

Second edition, first impression 2001

Production of this publication funded by:

Bank Supervision Department of the South African Reserve Bank
Financial Services Board

Published by:
SA Financial Sector Forum
www.finforum.co.za
P O Box 1148, Rivonia 2128
Fax: +27 (11) 802 3127
e-mail: info@finforum.co.za

This publication is available on the Internet at:

SA Reserve Bank: www.resbank.co.za
Financial Services Board: www.fsb.co.za
SA Financial Sector Forum: www.finforum.co.za

Set in Times New Roman/Arial 10/9 point

by the SA Financial Sector Forum

Printed and bound by Monty Print cc

Financial Regulation in South Africa

 FOREWORD

Financial regulation is a topic that does not enjoy a widespread or thorough understanding. It is often regarded as
obscure, arcane and yet another level of bureaucracy that has to be endured by the private sector. The importance
of designing and maintaining an efficient and effective system to regulate financial markets, financial institutions
and financial service providers lies at the very core of a nation’s economic wellbeing. The collapse of the banking
system in many Southeast Asian countries during the closing years of the twentieth century and the economic
hardships attendant on these events, are perhaps the most dramatic recent examples of how important the
implementation of efficient and effective financial regulation is.
The financial system in general, and the banking sector in particular, has experienced substantial structural
changes since the 1980s. One of the main challenges for financial regulators has been to keep up with and adapt to
these changes, which are often of an international nature. In South Africa the financial regulatory system has
undergone enormous change during this period, including the transfer of responsibility for banking supervision
from the Department of Finance (now known as the National Treasury) to the South African Reserve Bank in
1987, the establishment of the Financial Services Board in 1989 and the creation of the Policy Board for Financial
Services and Regulation by Act of Parliament in 1993.
An extract from the Mission Statement of the Policy Board reads: “The Board wishes to promote and maintain a
safe and sound financial system which will be fair to investors, effective in supplying financial services to all, well
structured and co-ordinated in terms of financial and regulatory matters.” It is in line with this objective that the
Policy Board has commissioned this report.
The report has the following aims:
• To capture the current “state of the art” of financial regulation in South Africa and the world.
• To catalogue and describe the underlying philosophy, guiding principles, ultimate objectives, intermediate
goals, and targets associated with financial regulation.
• To review experience and trends in local and international regulation.
• To draw conclusions about the effectiveness of current regulation in South Africa and what still has to be done.
I commend the reading of this report to all who wish to, or should, know more about financial regulation.
Obviously, this has been an ambitious project that is unlikely to satisfy everyone. The report contains
conceptual ideas of an exploratory nature and no recommendations should be construed as representing the
final view of the authorities.

Gill Marcus
Chairperson of the Policy Board for Financial Services and Regulation

Financial Regulation in South Africa iii

3
 PREFACE

In all countries, the financial system is more regulated and supervised than are other industries. On systemic and
consumer protection grounds alone, it is almost universally accepted that this should be so. Over time it has
become abundantly clear that regulatory arrangements have a powerful impact on (i) the size, structure and
efficiency of a financial system; (ii) the business operations of financial institutions and markets; and (iii)
competitive conditions both overall and between subsectors of the system. Depending upon how the objectives of
regulation are defined, and how efficiently regulatory arrangements are related to their objectives, the impact of
regulation can be either benign or malignant. Some regulatory structures are more likely to contribute to the
ultimate objectives than others. Accordingly, regulation has the capacity to do great harm, to be inefficient by
imposing unwarranted costs on regulated institutions, and even to be perverse (i.e. to operate counter to the
objectives of regulation).
The skill, therefore, is to seek regulatory institutions, structures and mechanisms that maximise the explicit
objectives of regulation while minimising imposed costs. This also means that effective mechanisms for
supervision and enforcement need to be instituted, as these are as important as formal regulatory requirements in
the overall regulatory regime. Effective regulation cannot secure its objectives in the absence of efficient
supervision and enforcement. The potential costs of regulation have to be viewed in a far broader light than the
actual transactions costs incurred. In particular, the impact on the economy as a whole and the cost imposed on
consumers should be considered.
The devising of effective regulation is comparatively easy when six “ideal conditions” are satisfied:
• Competitive pressures in the financial system are weak;
• the financial system is based on subsets of specialist financial institutions, each conducting a narrow range of
business, so that there is a reasonably precise parallel between function and institution;
• the structure of the financial system and the business operations of financial institutions are reasonably stable;
• the moral suasion of the regulatory agencies is universally accepted;
• the business of financial firms is predominantly domestic in nature; and
• simple and limited objectives of regulation are set.
The more the actual conditions move away from these “ideal conditions”, the more complex and challenging the
regulatory process becomes. For regulation to be effective (in that it contributes to its objectives) as well as cost-
efficient it has to adapt and respond to changes in institutional and market circumstances. The more these change,
the more flexible the regulatory arrangements should be. Conversely, regulation becomes more demanding, and
has to be more adaptable, as the objectives of regulation become more subject to change (more particularly the
balance between systemic stability, efficiency and consumer protection). Moreover, as the competitive
environment in the financial system becomes more intense and less stable, the business practices of financial
institutions and the overall structure of the financial system in turn become increasingly subject to change.
In many countries the financial system in general, and the banking sector in particular, are passing through a
period of substantial structural change. The system is subjected to the combined impact of internal competition,
global competitive pressures, changes in regulation, new technology and the fast-evolving strategic objectives of
financial institutions and their existing and potential competitors. The past two decades resulted in major
diversifications (e.g. under the pressure of deregulation and competition), and there was a decisive shift towards
the emergence of financial conglomerates. Above all, the competitive environment intensified markedly as banking
and other sectors of the financial system faced more inter-sector competition, increased competition from a more
innovative capital market, and global competitive pressures.

Financial Regulation in South Africa v

 It seems that during the next decade, the challenges for regulation will remain formidable for three central
reasons: (i) the process of structural change will continue, which will require regulation to adapt to, and efficiently
reflect, the changing competitive and structural environment; (ii) what is required of regulation has become more
extensive, and some of these requirements may be in conflict; and (iii) the environment will be particularly
demanding, as each of the six “ideal conditions” noted above will become increasingly undermined.
In many countries the institutional structure of regulation has recently changed or is in the process of being
changed. Different models of institutional structure are available. For instance, some countries (notably the UK)
have adopted the mega-regulator concept where all regulation is placed within a single, all-embracing agency.
Australia, on the other hand, has adopted the “Twin Peak” approach whereby two agencies are created: a single
prudential regulator for all institutions, and a single conduct of business regulator for all financial services. There is
no universally accepted ideal model.
Many different criteria can be applied. However, when considering the structure of regulatory institutions, a
major issue is how the requirement for adaptability can be achieved. The key is how to devise a structure of
regulatory institutions so that regulation has the maximum potential to adapt to changing conditions. A major issue
in this dimension is the role of consultation between the regulator and regulated, and the extent of participation of
the regulated in the regulatory process. The two cases are at opposite ends of a regulatory spectrum: the regulator
imposing regulation with Olympian detachment, versus self-regulation with minimum external interference. In
practice both extremes are untenable, though this still leaves open the issue of at what point along the spectrum the
balance is to be struck.
This report is directed at those interested in or affected by financial regulation and, particularly, financial
regulators. The objectives of the research are to
• provide comprehensive information about the theory and practice of financial regulation;
• discuss, in particular, the objectives, goals, targets and instruments of regulation, as well as their alignment;
• focus on the issue of the appropriate balance between statutory regulatory constraints and market incentives;
• discuss international trends in regulation and how regulation evolved in South Africa;
• suggest a possible future regulatory regime for South Africa and identify the key issues associated with such a
regime; and
• suggest areas for further investigation and research.
The approach of this report will be along the following lines: Chapter 1 discusses the relationship between the
overall regulatory philosophy of the government and the generally accepted regulatory objectives and principles.
Chapter 2 focuses more specifically on regulatory objectives and the goals, while Chapter 3 highlights the arsenal
of regulatory instruments available within the overall regulatory regime. Chapter 4 combines the instruments and
objectives of regulation into an overall regulatory matrix. Chapter 5 examines financial crises, the lessons learnt
and the regulatory responses. Chapter 6 describes the current regulatory structure in South Africa, discussing it in
terms of financial instruments, markets and institutions. Chapter 7 views regulatory changes in South Africa over
time with three snapshots: the regulatory structure in the 1980s, the structure in the 1990s and the likely structural
scenario by 2010. This chapter includes an executive summary of outstanding policy issues and the priorities in
South African financial regulation.
Although the authors take full responsibility for the content of the report, we gratefully acknowledge the
contributions of the following people: Rob Barrow; Patrick Birley; Graeme Brookes; Kevin Daly; Rinno Kuitert;
Tom Lawless; Peter Redman; Bob Tucker; Bill Urmson; Philip van der Walt; Franso van Zyl and Melonie van Zyl.

The task group of the Policy Board for Financial Services and Regulation
Johannesburg: August 2000

vi Financial Regulation in South Africa

 CONTENTS

Chapter 1: PHILOSOPHY, OBJECTIVES AND PRINCIPLES OF FINANCIAL REGULATION 1

1. Introduction 1
2. General philosophy 1
3. Objectives of regulation 2
4. Regulatory principles 3
4.1 Efficiency-related principles 3
4.2 Stability-related principles 5
4.3 Conflict-conciliatory principles 6
4.4 Principles related to the regulatory structure 7
4.5 General principles 8
5. Conclusion 10

Chapter 2: THE RATIONALE AND OBJECTIVES OF REGULATION 11

1. Introduction 11
2. Rationale for regulation 11
2.1 Systemic issues associated with externalities 12
2.2 Market imperfections and failures 12
2.3 Economies of scale in monitoring 13
2.4 Consumer confidence 15
2.5 Consumer demand for regulation 15
2.6 The “gridlock” problem 16
2.7 Moral hazard 16
3. Hazards in regulation 17
4. Objectives, intermediate goals and targets of regulation 17
4.1 Objectives of regulation 18
4.2 Intermediate goals of regulation 18
4.3 Targets of regulation 22

Chapter 3: THE REGULATORY REGIME 26

1. Introduction 26
2. Alternative approaches 26
3. The components and instruments of the regulatory regime 31
3.1 Rules and regulations 31
3.2 Official monitoring and supervision 32
3.3 Intervention and sanctions 32
3.4 Incentive contracts and structures 33
3.5 Market monitoring and discipline 34
3.6 Corporate governance 36
3.7 Discipline on and accountability of the regulators 37
4. Instruments of regulation 37

Financial Regulation in South Africa vii

Chapter 4: AN INTEGRATED TARGET-INSTRUMENT APPROACH
TO FINANCIAL REGULATION 41
1. Introduction 41
2. The overall regulatory strategy matrix 42
3. The regulatory regime and intermediate goals 42
3.1 Rules and regulations 45
3.2 Official monitoring and supervision 59
3.3 Intervention and sanctions 60
3.4 Incentive contracts and structures 61
3.5 Market monitoring and discipline 64
3.6 Corporate governance 67
3.7 Discipline on and accountability of the regulators 69
4. Deregulation and reregulation 76
4.1 Deregulation 78
4.2 Reregulation and self-regulation 80
5. Summary 81

Chapter 5: REGULATORY RESPONSES TO GLOBAL FINANCIAL DISTRESS 83

1. Introduction 83
2. Underlying causes of financial crises 83
2.1 Macroeconomic causes of financial crises 84
2.2 Regulatory causes of financial crises 86
3. Global regulatory responses to financial crises 88
3.1 Improvements in the financial system’s infrastructure 88
3.2 Enhancing market discipline and sanctions 91
3.3 Improving the supervision, monitoring and enforcement
capabilities of all players 92
3.4 Promoting monetary and financial stability 100
3.5 Regulatory arrangements 103
3.6 Recent trends in regulatory practice 112
3.7 Summary 114

Chapter 6: THE CURRENT REGULATORY STRUCTURE OF THE SOUTH AFRICAN

FINANCIAL SYSTEM IN THE INTERNATIONAL CONTEXT 116
1. Regulation of financial instruments 116
1.1 The definition and nature of financial instruments 116
1.2 The regulatory regime and structure for financial instruments 116
2. Regulation of financial markets 118
2.1 Difficulties in defining a financial market 118
2.2 The nature of over-the-counter and regulated markets 121
2.3 The instruments traded on financial markets 123
2.4 The aggregation of financial instruments into basic markets 125

viii Financial Regulation in South Africa

 2.5 Types of financial markets and their regulation 126
2.6 The regulatory regime and structure of financial markets 133
3. Regulation of financial market participants 140
3.1 Financial market participants 140
3.2 The regulatory regime and structure for financial market participants 144

Chapter 7: ASSESSMENT OF THE FINANCIAL REGULATORY REGIME IN SOUTH AFRICA 154

1. Introduction 154
2. The evolutionary trends in South African financial regulation 154
2.1 The socio-economic environment during the past few decades and
prospects for the next decade 155
2.2 The regulatory regime in the 1980s 157
2.3 The regulatory regime of the 1990s 159
2.4 The expected regulatory regime in the 2000s 162
3. Regulatory targets and gaps 169
3.1 Competitive market infrastructure 169
3.2 Acceptable maturity and currency mismatches 170
3.3 Acceptable cross-market exposures 171
3.4 Sufficient market liquidity 172
3.5 Securities markets as an alternative to financial intermediation 173
3.6 Regulatory effectiveness, efficiency and economy 174
3.7 Proper risk assessment 176
3.8 Proper financial institutional infrastructure and suitability standards 178
3.9 Global institutional competitiveness and competitive neutrality 178
3.10 Integrity, fairness and competence 179
3.11 Adequate product and service competitiveness 180
3.12 Transparency and disclosure 180
3.13 Adequate access to retail financial services 181
3.14 Protection of retail funds 182
3.15 Retail compensation schemes 183
4. Conclusion 184
4.1 Summary 184
4.2 The way forward 185

INDEX 189

Financial Regulation in South Africa ix

 Chapter 1
PHILOSOPHY, OBJECTIVES AND PRINCIPLES OF
FINANCIAL REGULATION
1. Introduction
Financial regulation can be approached from three
different – albeit complementary – perspectives.
Firstly, there is the perspective of general philosophy.
This is essentially a discussion of the nature of
regulation, and describes the rationale of regulation
and the philosophical approach of a country to the
regulation of financial sector activity. Secondly, there
is the perspective relating to the specific objectives to
be attained through the regulation of financial sector
activity. Thirdly, there is the perspective concerning
the broader principles to be applied when formulating
regulatory arrangements and structures for the
financial sector. Although these three perspectives are
closely related, it makes sense to discuss each
separately. From the viewpoint of the financial sector
practitioner the discussion will be on the principles
that are most visible and, at the operational level, that
are immediately relevant.
2. General philosophy
In any country the general philosophy of financial
regulation is, to a considerable extent, shaped by the
accepted norms and conventions of the financial
community, as well as the general philosophies and
ideologies supported by the political authorities. From
a broader perspective, the discussion of the general
philosophy can be pursued at two levels. At the higher
level the discussion revolves around the ideologies
regarding the role and operation of economic markets
(financial markets in particular), whereas at the lower
level the concern is more with the specific role
assigned to the regulation of the financial sector.
With regard to the higher level, the role of regulation
should reflect the views of the type of economic
system that is appropriate for a country. Currently,
Financial Regulation in South Africa: Chapter 1
industrial countries and many developing economies
place a considerable premium on a market-oriented
approach. This approach assumes that the working of
the market mechanism will, in general, produce the
best results in terms of efficiency and the allocation of
financial resources. The efficient allocation of such
resources would also imply an efficient allocation of
physical resources. Consequently, in most countries
the general philosophy is firmly anchored on the belief
that market mechanisms produce optimal decisions
and resource allocation. However, it is also
acknowledged that the market mechanism does not
operate perfectly under all circumstances and that the
role of regulation is to provide redress against
identified shortcomings and market imperfections. In
other words, allowance has to be made for the use of
regulation to secure a high degree of overall economic
efficiency, thereby compensating for the negative
aspects of unfettered market activity.
With regard to the lower level, the specific problems
of financial markets are at issue. It is recognised that
financial markets have their own unique
characteristics, and that participants in these markets
differ from participants in other markets in so far as
their activities have a more general impact on
economic activity. Accordingly, the working of
financial markets as a whole should facilitate rather
than impede the efficient operation of the financial
system. Regulation therefore has to be both effective
(in that it achieves the objectives) and efficient (i.e. is
cost-effective in the use of resources). There is also an
important economic dimension in that regulation
should not impose unwarranted costs on the economy
and consumers nor impair the efficiency of financial
markets. This dimension also considers whether the
objectives of regulation could be achieved in less
costly ways. These considerations can be judged
1
following cost-benefit analyses of regulatory
requirements. There should always be an awareness
that specific regulation can inflict damage if it is either
flawed or incorrectly applied. In such a case it would
actually impair the working of the market mechanism
and produce perverse results – i.e. counter to the
objectives of regulation.
It is also at this lower level that the nature of the
process of regulation1 has a considerable role to play.
The process of regulation consists of two basic
activities: the provision of guidance and the imposition
of constraints. More specific arguments in favour of
regulation are that there may be a need to redress
monopoly powers, to compensate for spill-over costs
owing to market imperfections such as moral hazard or
“gridlock” problems2, and to facilitate the
dissemination of adequate market information.
Regulation in finance also has a major “consumer
protection” role as consumers may not always have
sufficient information upon which to make
judgements, and the failure of financial contracts may
impose considerable hardship on consumers. To
ensure fairness to consumers, the regulatory authorities
have to set guidelines and operational constraints
which address inter alia moral hazard problems.
The general philosophy regarding the regulation of
financial markets therefore implies that the regulatory
authorities and the regulated parties both have an
interest in the creation and maintenance of an effective
and efficient system of regulation.
3. Objectives of regulation
Given the general philosophy, it follows that the
ultimate objective of regulation should be to achieve a
high degree of economic efficiency and consumer
protection in the economy. At a more practical level,
1
The term regulation is used in a generic sense that encompasses
regulation (the establishment of specific rules of behaviour),
monitoring (observing whether the rules are obeyed), supervision
(the more general observation of the behaviour of financial firms)
and enforcement (ensuring the rules are obeyed).
2
See Chapter 2, Section 2.6 for further details.
2 Financial Regulation in South Africa: Chapter 1
however, three specific objectives of regulation are of
particular relevance:
• Securing systemic stability in the economy: For
any economy it is of the utmost importance that its
financial markets run smoothly and are not
subjected to shocks of their own doing, caused
inter alia by: ineffective or inefficient trading,
clearing and settlement systems; poor market
infrastructures; or a major lack of market liquidity.
Another major consideration in this regard would
be the maintenance of the integrity of the payments
system and, in financial markets, the securities
delivery system3.
• Ensuring institutional safety and soundness: In
their efforts to promote efficiency, the regulatory
authorities should exercise extreme caution not to
impose – even inadvertently – regulatory obstacles
or barriers that would impair the safety and
soundness of financial institutions irrespective of
whether or not there is a systemic dimension.
Firms have to be adequately profitable, have
sufficient capital to cover their overall risk
exposures, be able to face global competitive
forces and also have “suitable” directors,
management and staff.
• Promoting consumer protection: Wherever
asymmetric information flows are evident, and
where the consumer can potentially be exploited,
there is an important “consumer protection” role
for the regulatory authorities. Integrity,
transparency and disclosure in the supply of
financial services have to be promoted. These
services have to be supplied by competent staff and
consumers should have access to the full spectrum
of retail financial services. In instances where
consumers are wronged, there should be effective
and cost-efficient compensation arrangements.
Even with this limited number of objectives,
conflicts can arise between them. For instance,
increased competition may result in greater efficiency,
but may adversely affect the stability of the financial
3
Called DVP – i.e. delivery versus payment
system. Likewise consumer protection measures, such
as single-capacity trading, may impact adversely on
competition and hence efficiency.
The more objectives that are set the more demanding
the regulatory process becomes. This is especially so
because the complexity of the financial system and of
the business operations of institutions increases.
Efficient regulation requires a multi-dimensional
approach, which in turn entails an optimising process.
Firstly, the approach requires a clear definition of
objectives. Secondly, the impact of each regulatory or
deregulatory measure on each objective needs to be
measured. Thirdly, an appropriate structure of
regulatory arrangements should be devised, taking the
above into account. Fourthly, the fulfilment of all
aspects of policy (and not only regulation) becomes
more difficult as the number objectives to be satisfied
increases, most especially if different policy agencies
are involved. This suggests a prima facie case for a
simple set of objectives.
Care should be taken not to make the objectives
unnecessarily sophisticated. Any move in such a
direction would undermine the efficiency of regulation
in contributing to its objectives. The aim should be,
therefore, not to encumber regulation with a
multiplicity of objectives that it is ill equipped to
deliver. This is not intended to deny the legitimacy of
other (perhaps social) objectives that may be secured
through financial mechanisms. However, these are
more appropriately attained by other means (e.g. tax
incentives) rather than by regulation. An example may
illustrate this point. Suppose the authorities wish to
encourage a distribution of investment different from
what the market mechanism – based upon the risk-
reward criteria of financial institutions – would
achieve. In this case, rather than impose, say,
prescribed asset requirements which would result in a
suboptimum portfolio, a more efficient approach
would be to offer tax incentives to take up such
investments. A further example from the UK, relating
to competition and contestability, is provided in Box
1.1 overleaf. This example is also of relevance to
South Africa – see Box 1.2.
Financial Regulation in South Africa: Chapter 1
Therefore, financial regulation should be restricted
to a narrow range of objectives – it should not be
employed as a means of achieving the wider economic
and social objectives of the political authorities. This is
so for three crucial reasons. Firstly, the regulation of
financial institutions and markets is not the most
efficient way of securing wider social objectives.
Secondly, the wider the objectives, the greater the
complexity of regulation as well as the potential for
conflicts. Thirdly, these wider objectives are
legitimately in the realm of the public accountability of
the political rather than the regulatory authorities.
Moreover, it is extremely hazardous to involve
regulatory authorities in wider political issues. In
short, the objectives of financial regulation should not
be political issues.
4. Regulatory principles
The third dimension of regulation refers to a set of
principles to be applied when formulating regulatory
policies, specific regulatory requirements and the
structure of regulatory institutions. The principles are
derived from the philosophy and objectives and can be
grouped into five categories: (i) efficiency-related
principles; (ii) stability-related principles; (iii) conflict-
conciliatory principles (relevant to address potential
conflicts between objectives); (iv) regulatory-structure
principles; and (v) general principles.
4.1 Efficiency-related principles
Principles classified in this category are designed to
contribute to the promotion of a high level of
efficiency in the provision of financial services. Two
such principles can be identified:
• Promoting the maximum level of competition
among market participants in the financial system;
and
• securing competitive neutrality between actual or
potential suppliers of financial services.
The reason generally advanced for promoting a
maximum level of competition among market
participants is that competition is likely to enhance
market efficiency. Efficiency is further increased if
3
competition causes the removal of restrictive practices
that impair trading in financial assets and the
rationalisation of market activity. The maximum
attainable level of competition requires relative
freedom of entry into the financial services industry as
well as relative freedom of choice regarding the
financial services that any market participant chooses
to provide. Taking note of the globalisation of
financial markets, such freedom of entry should be
allowed also in the case of foreign participants, and in
turn local market participants should have (virtually)
unrestricted access to global financial markets.
In the financial market environment, the maximum
attainable level of competition among market
participants implies full competition among financial
exchanges and involves all market procedures and
modes of trading. As a consequence of the relatively
small size of the South African financial market, as
well as the extent of the facilities being offered, market
efficiency with regard to competition can only be
optimised if such competition leads to maximum
rationalisation in market structures and procedures. A
factor militating against the optimisation of market
efficiency is the fact that the South African financial
markets are not fully integrated into the global markets,
mainly owing to exchange control regulations.
The achievement of competitive neutrality between
market participants would promote a high level of
efficiency. Competitive neutrality could be defined as a
situation in which no party to a financial transaction
would enjoy a competitive advantage as a result of
regulation, and different suppliers of financial services

Box 1.1: Limiting the objectives of financial regulation:

Competition and contestability1 – United Kingdom
In a situation where an industry is not contestable, mergers and acquisitions (M&As) have the inherent danger that
they reduce competition (at least in the domestic market). At the same time M&As may improve systemic risk
management and institutional soundness and even efficiency. There is currently a debate on a recommendation
that: (i) the financial regulatory authorities should become involved in M&A policy; and (ii) contestability in
competition policy should be included as an explicit objective of the UK’s Financial Services Authority (FSA).
There are several reasons for doubting the wisdom of this: (i) it would almost certainly create conflicts of interest
within the FSA, and the FSA could defend almost anything it did by arguing that it was balancing the conflicting
objectives of contestability and other objectives it is required to meet; (ii) it would therefore make the FSA’s
accountability more uncertain as there would be too many escape routes; (iii) the FSA’s objectives would become
too diffused and unfocused; (iv) there would be a potential danger of regulatory overload as more objectives
became added; and (v) applying the “target-instrument” paradigm,2 the legitimate and very important public policy
objective of sustaining and enhancing competitive conditions in all markets would be more efficiently pursued by a
dedicated agency which did not have internal conflicts.
Assessment and the evaluation of the effect of activities such as M&As on competition are more powerful
when made by an external agency (e.g. in the UK, the Office of Fair Trading (OFT)). In addition, the resolution of
conflicts, in the final analysis, may often involve judgements that have a political dimension and this should be
made explicit rather than somehow resolved internally within the FSA. The UK’s approach in its Financial Services
and Markets Bill (whereby the FSA is required to be conscious of the competition implications of its actions) is a
more appropriate approach. The current practice (whereby the OFT is required to scrutinise the competition
implications of regulatory agencies in relation to activities such as M&As) works well and is more efficient than
internalising the process by establishing competition enhancement as an explicit objective of the regulator.
________________________
1
An industry is said to be contestable if there are low barriers to entry and exit. For instance, should M&A activity reduce
competition in the domestic banking industry resulting in excess profits, there would be no barrier to the entry of foreign banks.
2
The target-instrument approach establishes that, when each instrument differentially affects each target, all targets can be
achieved simultaneously only if there are as many instruments as targets: i.e. there exists some combination of instruments
that achieves the desired combination of targets (see Chapter 4 for a further discussion).

4 Financial Regulation in South Africa: Chapter 1

would not have regulatory advantages. From a
regulatory perspective this would involve the creation
of a “level playing field” for the concluding of
financial transactions. In practice this would require
competitively neutral legislation as well as the
avoidance of any form of functional or institutional
discrimination against particular market participants
(see Section 4.4 below). In addition, it is important to
pursue a minimalist approach to regulation in the sense
of redressing only inherent market deficiencies such as
externalities4, moral hazards, imperfect competition
and natural monopolies. Imperfect competition and
natural monopolies could be effectively removed by
abandoning regulations and such factors as would
impede the necessary rationalisation of market activity.
4.2 Stability-related principles
Principles in this category should contribute to the
4
Externalities would include any discriminatory imposts (i.e. taxes,
levies or fees) or subsidies, which have effects analogous to
regulatory differentiation between market participants, categories
of market participants and types of transactions.
promotion of a high measure of stability in the
financial system, and an appropriate degree of safety
and soundness in financial institutions. Three such
principles can be identified:
• Incentives for the proper assessment and
management of risk;
• the use of regulatory requirements (e.g. related to
capital) based, where possible, on current market
values rather than historic values; and
• a willingness of the regulators to take timely action
to redress developments threatening the existing
and future stability of financial institutions and
markets.
The proper assessment and management of risk
requires the identification and successful handling of
such risks. To the extent that the regulatory authorities
do not wish to be concerned with day-to-day risk
management, they should at least impose acceptable
minimum prudential standards to be observed in respect
of risk management by all financial sector participants.
Appropriate information systems are required for the
successful and timely identification of the relevant

Box 1.2: Limiting the objectives of financial regulation:

Contestability and mergers and acquisitions – South Africa
Late in 1999, the Standard Bank Investment Corporation (Stanbic) was on the receiving end of a hostile +R30 bn
(US$5 bn) takeover bid from Nedcor Limited. Of competitive significance are the facts that Nedcor is effectively a
subsidiary of the SA insurance giant, Old Mutual plc, while Stanbic also controls the large Liberty Life SA
insurance company. It may be noted that the South African banking industry is not contestable because of
exchange controls and constraints on foreign banks’ deposit-taking activities. Clarification is required on the
responsibilities of the Registrar of Banks (SA Reserve Bank) and the Competition Commission with regard to this
and future mergers. In 2000, the Courts ruled that the Minister of Finance in terms of the Banks Act should judge
Nedcor’s bid. The Courts found that the Competition Act did not apply because of provisions which exempt “acts
subject to or authorised by public regulation”. The ruling raises the prospect that deals in numerous sectors, such
as insurance, telecommunications and liquor retailing, will fall outside the ambit of the competition watchdog.
This ruling appears to explicitly assign the handling of mergers and acquisitions as an objective of the financial
regulators albeit after consultation with the Competition Commission. According to the Minister of Trade and
Industry, the ruling was an extreme interpretation, which ruled in favour of exclusivity, and companies would use
this as a precedent. It was always the intention of the Competition Act that mergers and acquisitions should be
subject to both the competition law and legislation regulating particular sectors. The Minister of Trade and Industry
wishes to amend the Act to make it clear that concurrence was intended between the Competition Act and other
regulatory statutes – except that the Competition Commission shall not have jurisdiction where the Minister of
Finance issues a notice that the proposed merger is in the best interests of the stability of the financial system in
the Republic. This matter is still under debate.

Financial Regulation in South Africa: Chapter 1 5

risks. Successfully dealing with the identified risks
would demand procedures for minimising risks and
establishing adequate capital requirements.
In financial markets, cross-market risk management
is inevitable, as market participants are likely to
operate in different financial markets simultaneously.
Therefore, provision should be made for the offsetting
of risks, for example between transactions in spot and
derivative markets. Since the management of risks is
to be conducted by market participants at all levels, the
introduction of “fit and proper” standards for
participants as well as for trading procedures should
enhance financial market stability.
From a stability perspective, the use of current
market values is extremely important. The viability of
an institution can ultimately be determined only by
reference to the current (rather than historic) market
values of balance sheet items. A major problem in the
US, for instance, was that for much of the 1980s many
Savings and Loan Associations were trading on a
technically insolvent basis obscured by a failure to
present accounts on a current-value basis. The
continuation of trading meant that the eventual degree
of insolvency, and hence the claim on the taxpayer
through the deposit-insurance system, became far
greater than would have been the case had initial
insolvency been detected earlier. This is a
controversial issue, particularly when the price of
some assets on the balance sheet is prone to volatility.
There is a discernable trend in accounting standards
towards greater sympathy with current-value
accounting concepts. Nevertheless, there are many
technical accounting problems to be solved before
current-value accounting can fully replace the
traditional historic-value accounting.
Developments threatening the existing and future
stability of financial markets that might have
additional disruptive consequences should be dealt
with expeditiously. The regulatory authorities, in their
role as the issuers of directives and in their capacity as
financial market supervisors, should take or initiate the
necessary corrective action whenever actual or
potential market deficiencies are detected. Postponing
6 Financial Regulation in South Africa: Chapter 1
action (“forbearance”) could cause an accumulation of
adverse effects and unwarranted contagion, which
could exacerbate the disruption of financial market
activity and consequently pose an ever greater threat to
the achievement of financial market stability. Again,
the US experience with Savings and Loan
Associations illustrates the costs of delayed action.
4.3 Conflict-conciliatory principles
As with the objectives of regulation, principles may
also be in conflict with one another. Conflict-
conciliatory principles are designed to resolve
potential conflicts between regulatory principles.
These conflict-conciliatory principles would involve
• following an integrated approach, aiming at the
simultaneous achievement of regulatory objectives;
and
• pursuing a target-instrument procedure, whereby
the regulatory instruments would be so selected
and applied that they would facilitate the
implementation of an integrated approach.
The target-instrument approach establishes that, when
each instrument affects each target, all targets can be
achieved simultaneously only if there are as many
instruments as targets: i.e. there is some combination of
instruments that achieves the desired combination of
targets. Therefore, the value of each instrument is set
not only to have positive effects on targets, but also to
neutralise the negative effects of other instruments. This
analysis, therefore, indicates that, if each of the
regulatory objectives is to be secured, a multi-
instrument approach is required. This is an optimising
approach designed to achieve satisfactory levels of
competition, soundness and safety. No single
instrument will suffice, and the more one objective is
sought, the greater the demand on other instruments to
offset the potentially negative effect upon other
regulatory objectives. Therefore, a co-ordination of the
various objectives and instruments is required. A good
example can be found in arrangements made for the
protection of the consumer. One way of dealing with
potential conflicts of interest that may work against the
interests of the consumer is regulation that restricts the
range of allowable business. If, for any reason, such
regulation is eased, it may be necessary to resort to
other measures to limit the potential for conflicts of
interest. Accordingly there may have to be recourse to
dedicated capital, Chinese walls, rules of conduct,
compliance officers, disclosure rules, etc.
4.4 Principles related to the regulatory
structure
A major issue in regulation, especially as financial
institutions become more complex and diversified,
relates to the structure of regulatory institutions and, in
particular, whether regulation and supervision should
be conducted on the basis of a multiplicity of specialist
agencies or by a single regulatory authority. Three
principles are established in this regard:
• The following of a functional as well as an
institutional approach to the regulation of financial
market activity;
• the co-ordination of regulation by different
authorities and agencies in order to achieve
consistency; and
• a presumption in favour of a small number of
regulatory agencies.
The problems of official regulation and supervision
multiply when a financial system develops multi-
functional institutions or financial conglomerates
rather than being based on clearly differentiated
functional institutions. A choice has to be made
whether institutions or functions are to be regulated
and supervised. In a differentiated system the problem
does not arise, as institutions and functions are
synonymous. Therefore, as structural change entails a
trend towards financial conglomerates, a choice has to
be made between functional regulation or
conglomerate regulation. In the former case, specialist
regulators and regulatory arrangements are established
to regulate and supervise clearly defined financial
activities independently of which institutions are
providing the service. This implies that a financial
conglomerate may be subjected to the jurisdiction of
several regulatory authorities. The alternative is
conglomerate regulation, where a single regulatory
Financial Regulation in South Africa: Chapter 1
authority is established to regulate and supervise all
aspects of financial institutions’ business.
Historically, the institutional approach has been
dominant, largely because institutions have tended to
be specialist in nature. Since the 1990s, however, more
emphasis is being placed on a functional approach to
regulation. The functional approach places more
emphasis on regulating a specific type of activity
irrespective of the type of institution involved. This is
perceived to be more pervasive, and the presumption is
that it would yield sounder results.
In practice, however, the institutional and functional
approaches need to be employed in parallel because
regulatory authorities are concerned with the
soundness of institutions – at both the level of the
institution and at a systemic level – as well as the way
in which particular services are provided. Therefore
although it is institutions that become bankrupt and not
functions, business practices relate to functions.
Accordingly, the approaches need to be synchronised,
and some common ground for such synchronisation is
found in the fact that risk identification and risk
management are common to both the institutional and
functional approaches. In terms of the functional
approach, self-regulation has adopted an important
role. The co-existence of self-regulation and official
institutional regulation requires proper co-ordination in
order to ensure regulatory consistency.
Self-regulation has always been a feature of the
South African financial market control system. There
is much to commend self-regulation – through
recognised bodies – especially if there are built-in
safeguards to protect against the obvious potential for
an abuse of authority. The self-regulatory body has the
required expertise and is in a position to monitor
financial innovations. The participants, being members
of the industry, have a professional interest in ensuring
that standards and public confidence are maintained.
They have an interest in ensuring that less scrupulous
financial firms do not gain a “free rider”5 advantage
5
Consumers assume that others have investigated the safety and
integrity of suppliers of financial services.
7
based upon the public’s positive perception of the
regulated industry. By eliciting the consent of the
regulated, a high degree of compliance with
regulations and standards can be secured. It may also
be the case that self-regulation is generally concerned
with standards, rather than the strict “letter of the law”
which may be the case with prescriptive legislative
regulation. This is particularly important when the
business is very technical and, in a competitive
environment, when financial innovation is an important
feature of the industry. Above all, self-regulation is
more likely to be flexible and adaptable to a changing
market environment than regulation based upon
legislatively imposed requirements. A consideration in
this regard is that it can prove difficult and time-
consuming to have the law amended or revised.
In terms of the functional approach, self-regulation
has become all the more important – indeed the
cornerstone of much financial regulation. The co-
existence of self-regulation and official institutional
regulation requires proper co-ordination to ensure
regulatory consistency. The regulatory structure that
has evolved over time could pose difficulties for the
achievement of proper co-ordination, as it may prove
difficult to merge the responsibilities or to reassign
them more effectively. To the extent that
responsibilities cannot be merged – the case of self-
regulation by a financial exchange and official
regulation by the statutory regulatory authorities – co-
ordinating mechanisms need to be introduced. Such
mechanisms may consist of co-ordinating boards,
committees, or “lead-regulator” arrangements. Without
co-ordination there is little likelihood of achieving
competitive neutrality between the different financial
market participants.
Related to cost-efficiency is the issue of the structure
and number of regulatory authorities and the
relationship between them. When a financial
institution, or financial activity, involves more than
one regulatory authority, there has to be effective co-
ordination and consistency between them as well as
consistent rulebooks and regulatory requirements.
The existence of numerous regulatory authorities
8 Financial Regulation in South Africa: Chapter 1
gives rise to the hazards of complexity,
inconsistencies, overlaps, duplication and higher
administrative costs. In principle, there must be a
general presumption that the fewer the regulatory
authorities, the fewer the problems of consistency and
co-ordination. However, this consideration must be
balanced against the advantage of efficiency to the
extent that this requires specialist regulators, especially
if there is a strong element of self-regulation. Self-
regulation is more effective as the regulated activity
becomes more specialised. It is a question of balance
between cost-efficiency and administrative
effectiveness. The issues are complex as has been
demonstrated in virtually all countries with split
regulatory responsibilities.
The question of the distribution of supervisory
responsibilities and co-ordination among different
authorities has acquired greater significance in the
light of the despecialisation and internationalisation of
institutions. National authorities remain divided as to
the merits of the centralisation of supervisory
responsibilities, with views being significantly
affected by the historical legal framework. There is
consensus, however, on the need for further co-
operation domestically and internationally in areas
such as the precise allocation of responsibilities, the
exchange of information and, to a lesser extent, greater
consistency of supervisory methods.
4.5 General principles
General principles are those that have a bearing on the
general conduct of the regulatory process. With one or
more regulatory instruments being employed in any
specific regulatory arrangement, the following general
principles may be formulated:
• Every regulatory arrangement should be related
explicitly to one or more of the objectives
identified.
• All regulatory arrangements should be justified
with respect to their cost-efficiency.
• The costs of regulatory arrangements should be
distributed equitably.
• All regulatory arrangements should be sufficiently
 flexible, in the sense of being amenable to changes
in markets, competition and the evolution of the
financial system.
• Regulatory arrangements should be practitioner-based.
Regulatory arrangements (especially with respect to
capital) should be precisely related to the objectives
they are designed to achieve. If regulatory
arrangements are not related to the objectives (in the
sense of being consistent with the objectives of
financial regulation), negative effects would be
inevitable. These negative effects would include the
discouraging of competition and the stifling of
financial innovation. Accordingly, it is essential that all
regulatory arrangements should be applied judiciously.
In the context of consumers valuing both the benefits
of regulation and competition, and with regulation
imposing costs both on consumers and the regulated,
regulatory structures and detailed regulatory
arrangements need to be based upon explicit cost-
benefit analysis. The requirement is that regulation
should be not only effective, but also cost-efficient.
Certain regulatory arrangements may be desirable in
terms of the regulatory objectives but may,
nevertheless, not be justified in terms of their wider
costs. Because of the increased complexity and the
wider range of financial services covered, the direct
costs of regulation have risen. Given these costs, a
judgement clearly has to be made as to how far the
objectives of regulation (e.g. protection of the
consumer from all possible abuse) can reasonably be
pursued and what cost is reasonable to bear. Leaving
aside the direct administrative costs, if the result of a
totally abuse-free and safe system means a serious
impairment of competition, the stifling of financial
innovation and the loss of business to foreign centres,
then a judgement has to be made, on cost-benefit terms,
whether further regulatory imposts yield diminishing
marginal returns and so cease to be cost-effective.
Regulation is not a free good and the costs of an
effective regulatory system and regulatory
arrangements are substantial. The question arises as to
who should bear such costs – two basic models are
employed in most countries as follows:
Financial Regulation in South Africa: Chapter 1
• The costs are borne by a government or parastatal
agency and hence by taxpayers in general. This is
not necessarily inequitable as a substantial number
of taxpayers are directly or indirectly the
beneficiaries of an effective regulatory system.
• The regulatory agency recovers its costs from the
institutions which it supervises. In practice this
means that the institutions pass on the costs of
regulation to their customers in their pricing
structures. It can be argued that this system is more
equitable since it places the costs of regulation with
those who benefit directly from such regulation,
i.e. the customers of the regulated institutions.
Neither the structure of financial systems nor the
business operations of institutions are static – both
evolve over time. Similarly, regulation should also
evolve, and a major principle to be applied is that
regulation should be a dynamic process which changes
to reflect the competitive climate and market
environment. If regulation moves out of step with
competition, serious business distortions and
inefficiencies are likely to arise. Sufficient flexibility of
regulatory arrangements would ensure the necessary
adaptability to changes and could assist in achieving the
regulatory objectives in an optimum fashion by
permitting the appropriate response to such changes.
Whether they be market changes or changes in
competitive positions, they emanate from the continuous
process of financial innovation as well as other
evolutionary forces present in the national economy.
For regulatory arrangements to be practitioner-
based, they need to be devised in consultation with
market participants. With consultations opening the
door for divulging information and responses between
regulators and the regulated, the industry would
contribute significantly to the development of the
regulatory system. Better results would be forthcoming
if such practitioner-based regulatory arrangements
were employed. By creating a better understanding
between the regulators and the regulated, practitioner-
based regulatory arrangements would serve the
additional purpose of facilitating the regulatory
process itself. Overall, explicit arrangements need to
9
be made to ensure that regulated institutions and
market practitioners participate in the establishment of
specific regulatory requirements.
5. Conclusion
Financial systems around the world are undergoing
major structural changes, owing largely to increased
competition. At the same time, regulatory
arrangements have also changed and become more
complex. In many countries a global dimension to
regulation has emerged. Today the tendency is to
harmonise national financial regulation with the
international standards set by bodies such as the
International Accounting Standards Committee
(IASC), the Basel Committee on Banking Supervision
(BCBS), the International Organisation of Securities
Commissions (IOSCO) or the International
Association of Insurance Supervisors (IAIS).
In a rapidly changing market environment,
10
traditional views about financial regulation should
always be subject to scrutiny and challenge. It should
never be taken as axiomatic that regulation is always
effective and efficient and precisely related to its
alleged objectives. If the ultimate purpose of
regulation is to protect the consumer and serve
systemic interests, then it should be subjected to the
test of whether it does so effectively and cost-
efficiently. It also requires that specific regulatory
arrangements should be subjected to the same test, for
arguments against particular mechanisms may not
invalidate the arguments for regulation in general. The
precise rationale of all regulatory arrangements and
structures needs to be succinctly identified rather than
taken for granted. Regulation should, therefore, be an
evolving process and responsive to changes in the
market environment. Indeed, regulation that remains
stable irrespective of changes to the financial system
will be inefficient at best and perhaps even perverse.
Financial Regulation in South Africa: Chapter 1
 Chapter 2
THE RATIONALE AND OBJECTIVES OF REGULATION
1. Introduction
Financial systems are prone to periods of instability in
developed and in developing countries. In recent years,
bank failures around the world have been common,
large and expensive. This suggests a case for more
effective regulation and supervision. There seem to be
three common elements in banking crises: (i) bad
incentive structures; (ii) weak management and control
systems within banks; and (iii) poor regulation,
monitoring and supervision. Financial crises are
discussed in Chapter 5.
This chapter considers the economic rationale for
financial regulation: why regulation has welfare
benefits, and why it is rational for (particularly retail)
consumers of financial services to demand (and
therefore pay for) the regulation of financial services
firms. It also reiterates the objectives of regulation and
breaks them down into intermediate goals and further
into regulatory targets.
It is useful to distinguish between the rationale for
regulation (why regulation is necessary if the objectives
are to be achieved), the objectives of regulation (what
outcome it is trying to secure) and the reasons for
regulation (why in practice regulation takes place). The
point of these distinctions is to differentiate between the
economic rationale of regulation as opposed to why, in
practice, regulation might be imposed.
2. Rationale for regulation
Seven components of the economic rationale for
regulation and supervision in banking and financial
services are identified:
• Potential systemic problems associated with
externalities.
• The correction of market imperfections and failures.
• The need for the monitoring of financial firms and
the economies of scale inherent in this activity.
Financial Regulation in South Africa: Chapter 2
• The need for consumer confidence, which also has
a positive externality.
• Consumer demand for regulation in order to gain a
degree of revealed preference for assurance and
lower transactions costs.
• The potential for “gridlock”, with associated
adverse selection and moral hazard problems.
• Moral hazard associated with the revealed
preference of governments for creating safety net
arrangements: lender-of-last-resort, bank deposit
insurance and compensation schemes.
“Consumer protection” issues arise for two main
reasons: the possible failure of an institution where
clients hold funds, or because a firm conducts business
unsatisfactorily with its customers. The failure of a
financial firm may have adverse effects on systemic
stability, and also cause loss to individual depositors
who are regarded as being unable to look after their
own interests. The impact that the failure of financial
institutions has on systemic stability and the interests of
consumers means that regulators are almost inevitably
bound to have a prudential concern for the liquidity,
solvency and riskiness of financial institutions. Such
regulation must necessarily focus on institutions per se.
Conduct-of-business regulation, on the other hand,
focuses on the functions of financial firms irrespective
of the type of firm conducting the business.
Each of these seven components will be discussed in
this section in greater detail. Before doing so it is
worthwhile to distinguish between the two generic
types of regulation and supervision, i.e. prudential
regulation and conduct-of-business regulation (see
Box 2.1 overleaf).
The seven components of the rationale for regulation
are discussed in the next two sections whereas the
objectives, intermediate goals and targets of regulation
are covered in the remaining sections.
11
2.1 Systemic issues associated with
externalities
Regulation for systemic reasons is warranted when the
social costs of the failure of financial institutions
(particularly banks) exceed private costs and such
potential social costs are not incorporated into the
decision making of the firm – see Box 2.2. Financial
institutions may be induced into more risky behaviour
than they would if the potential costs of all risks
(including those for the system as a whole) were
incorporated into their pricing. Systemic issues do not
apply equally to all institutions. They have
traditionally been central to the regulation of banks
based on four main considerations:
• The pivotal position of banks in the financial
system, especially in payments systems.
• The systemic dangers resulting from bank runs.
• The nature of bank (debt) contracts on both sides of
their balance sheet.
• Adverse selection and moral hazard associated
with safety net arrangements (lender-of-last-resort
facilities and deposit insurance).
2.2 Market imperfections and failures
If financial services were conducted in perfectly
competitive markets (i.e. if there were no information
problems, externalities, conflicts of interest, agency
problems, etc.) there would be no case for regulation,
and any regulation that was imposed would be a net
cost to the consumer. By contrast, if there are market
imperfections and failures but no regulation, the
consumer pays a cost because the unregulated market
outcome is suboptimum. Focusing only on the
accountancy cost of regulation (which can be

Box 2.1: Two generic types of regulation

Two generic types of regulation and supervision are identified: (i) prudential regulation, which focuses on the
solvency, safety and soundness of financial institutions, and (ii) conduct-of-business regulation which focuses on
how financial firms conduct business with their customers.
Prudential regulation
In practice consumers are not in a position to judge the safety and soundness of financial firms. Prudential
regulation is necessary because of imperfect consumer information, agency problems associated with the nature
of financial institutions’ business, and because the behaviour of a financial firm – after consumers have dealt with
it – affects the value of their stake in the firm. No amount of information, at the time contracts are signed or
purchases made, protects against the subsequent behaviour of the firm. Leaving aside any potential systemic
dimension, there is therefore a case for prudential regulation of financial firms when –
• the institution performs a fiduciary role.
• consumers are unable to judge the safety and soundness of institutions at the time purchases or contracts
are made.
• post-contract behaviour of the institution determines the value of contracts taken out by customers.
• there is a potential claim on an insurance fund or compensation scheme, because the costs of the hazardous
behaviour of an individual financial firm can be passed on to others (those who in the end pay the
compensation). If other firms in the industry are required to pay the compensation liabilities of failed institutions,
they demand certain minimum standards of behaviour which they are unable to enforce themselves without an
external agency’s intervention.
Conduct-of-business regulation
Conduct-of-business regulation and supervision focuses upon how financial firms conduct business with their
customers. It focuses upon mandatory information disclosure, the honesty and integrity of firms and their
employees, the level of competence of firms supplying financial services and products, fair business practices, the
way financial products are marketed, etc. Conduct-of-business regulation can also establish guidelines for the
objectivity of advice, with the aim of minimising those principal-agent problems that can arise when principals
(those seeking advice) and agents either do not have equal access to information, or expertise to assess it.

12 Financial Regulation in South Africa: Chapter 2

measured) overstates the true cost of regulation
because it does not incorporate the value of the
consumer benefit if the effects of market imperfections
are alleviated.
The ultimate rationale for the aspect of regulation
designed to protect the consumer is to correct for
market imperfections or market failures, which would
compromise consumer welfare in a regulation-free
environment. There are many market imperfections
and failures in retail financial services:
• Problems of inadequate information on the part of
the consumer.
• Problems of asymmetric information – consumers
are less well-informed than the suppliers of
financial services.
• Agency costs – asymmetric information can be
used to exploit the consumer.
• Potential principal-agent problems and issues
related to conflicts of interest.
• Problems of ascertaining quality at the time of
purchase.
• Imprecise definitions of products and contracts.
• The inability of retail consumers to assess the
safety and soundness of financial institutions
except at inordinate cost.
• Consumer under-investment in information and
resultant “free-rider” problems – i.e. whereby
consumers assume that others have investigated the
safety and integrity of suppliers of financial
services.
• Consumers are not all equally equipped to assess
quality, etc., because of the technicalities of some
financial products.
2.3 Economies of scale in monitoring
Because of the nature of financial contracts between
financial firms and their customers there is a need for
the continuous monitoring of the behaviour of
financial firms. There are several characteristics of, at
least, some financial products that require a continuous
process of monitoring the suppliers of products: it is
often the case that long-term contracts are involved;
principal-agent problems can arise; the quality of a
financial product cannot be ascertained at the time of
purchase; and there is often a fiduciary role for the
financial institution (see Box 2.3 overleaf). Above all,
the value of a product is determined by the behaviour
of the supplier after products have been purchased and
contracts entered into. This is particularly significant
for long-term contracts, since the consumer is unable
to exit at low cost. To some extent it may also apply to
bank depositors – although they can exit at low cost,
depositors may not have the necessary information to
make such a decision timeously.
The question is who is to undertake the necessary
monitoring of the behaviour of financial institutions:
e.g. customers, shareholders, or rating agencies.
Because most (especially retail) customers are not, in
practice, able to undertake such monitoring, an
important role of regulatory agencies is to monitor the
behaviour of financial firms on behalf of customers. In
effect, consumers delegate the task of monitoring to a
regulatory agency.
There are potentially substantial economies of scale
to be secured through a collective authorisation (via
“fit and proper” criteria), and the supervising and
monitoring of financial firms.

Box 2.2: Social and individual cost of bankruptcy

In the case of a bank failure the shareholders may lose all their investments in the bank concerned, which
represents the private cost of failure. However, even the bankruptcy of a small bank may have serious ripple
effects for other banks or even the payments and settlement system at large. The cost where people start to
believe that money is safer under their mattresses than in their bank deposits is the social cost of bank failure and
which is usually a multiple of the private costs. A classic example is the bankruptcy of the smallish German bank,
Bankhaus Herstat in 1974 that resulted in a major contraction of credit in the Eurobond market at the time. The
regulatory authorities are most concerned with the social costs of bankruptcies and their impact on systemic risks.

Financial Regulation in South Africa: Chapter 2 13

 Box 2.3: Nature of financial products and services
Financial products and contracts are different from most other consumer goods and contracts.
A central issue in the rationale for the regulation of financial services is the extent to which financial products,
contracts and services differ from many other goods and services that are not regulated to the same degree.
The key issue is how the consumer ascertains quality, and hence value for money, and the appropriateness of
the product or service being purchased.
In practice, there are significant differences between (some) financial and non-financial services and these
differences are of a degree that makes a case for regulation in finance which does not apply to other goods and
services. These special characteristics include the following:
• Financial products are often not purchased frequently and hence the consumer has little experience or ability to
learn from experience.
• The consumer often lacks confidence in making purchases of financial contracts.
• There is a lack of transparency – it is difficult to verify the claims being made by the seller.
• The consumer frequently requires advice when purchasing financial products – this gives rise to principal-agent
problems.
• It is often easy for a financial salesperson to conceal relevant information and/or mislead the consumer.
• It is usually difficult to detect misrepresentation at the time of purchase.
• The full cost of the product may not be known at the point of purchase and it may sometimes be concealed
from the consumer.
• The product cannot be tested ahead of purchase.
• Value is not immediately clear at the time of purchase – the consumer cannot know if a bad product is being
purchased.
• Value is often critically determined by the personal circumstances of the purchaser.
• The value of contracts is determined by the behaviour of suppliers after purchases have been made; this
creates the potential for opportunistic behaviour and gives rise to a need for monitoring. No amount of
information available at the time of purchase can guard against this potential hazard.
• The consumer’s future welfare often depends on the performance of the contract: a faulty product can be
replaced, but a bad financial contract cannot be surrendered other than at a (sometimes substantial) cost.
• There is no guarantee or warranty attached.
• Faults cannot be rectified.
• The value of a financial contract rises over time whereas the value of most other products declines. This lowers
the net replacement cost of the latter in the event that, at some time in the future, it needs to be replaced due to
a fault.
• It may be a long time (if at all) before the consumer is aware of the value and faults of a financial contract. This
limits the power of reputation as an assurance of good products. Even if, in the long run, reputation is damaged
by bad behaviour, consumer wealth is impaired in the meantime.
• The purchase often creates a fiduciary relationship with the company, which takes on the responsibility for
managing the client’s investment or savings.
• Information on reliability is difficult to obtain.
• If the firm becomes insolvent during the maturity of the contract, the contract’s value may be lost.
These characteristics mean that, in practice, the transactions costs for the consumer in verifying the value of
contracts (even when this can be done at all) are high. Because of the nature of the products and contracts,
producers can easily mislead the consumer and this may not be detected for many years, and sometimes not until
the contract matures, by which time irreparable damage may have been done. In these circumstances, it may not
be sufficient to rely on the reputation of the supplier.
This means that, in some circumstances (including finance), enforceable and monitored regulation (which has a
cost attached) can be justified as an alternative to high transactions costs for consumers. Put another way, the
costs of regulation should not be compared with a zero cost base but with the costs imposed on the consumer by
any alternative to regulation, e.g. monitoring and verification costs.

14 Financial Regulation in South Africa: Chapter 2

2.4 Consumer confidence
The known existence of asymmetric information can
reduce consumer demand for services and contracts. In
a situation where consumers know there are good and
bad products or firms, but are unable to distinguish
among them at the time of purchase1, the demand for
some products may decline. Under some circumstances,
and with known asymmetric information features, risk-
averse consumers may exit the market altogether.
When consumers know there are low-quality
products in the market, good products and firms may
become tarnished by the generalised reputation of poor
products and firms. An additional role of regulation,
therefore, is to set minimum standards and thus
remove any “lemons” from the market. In this sense,
suppliers may also have an interest in regulation that
sets minimum standards and enhances confidence in
the market.
2.5 Consumer demand for regulation
Given that regulation sometimes fails, and has its own
costs and problems, some argue the case for private
self-regulation reinforced by common, commercial and
contract law. One rationale for regulation is that public
pressure may resist such an alternative. Although there
are costs involved, the consumer may demand the
degree of comfort that can only be provided by
regulation, supervision and various forms of
compensation mechanisms. There is an evident
consumer demand for regulation and hence,
irrespective of theoretical reasoning, a welfare gain
(and perhaps political gain) to be secured if, within
reason, this demand is satisfied.
There are several reasons that it can be rational for
the consumer to demand regulation:
• Lower transactions costs for the consumer (e.g.
saving costs in investigating the position of
financial firms, or costly analysis);
• Consumers’ lack of information and inability to
utilise information;
1
Because of insufficient and credible information or because the
quality is revealed only after the lapse of time.
Financial Regulation in South Africa: Chapter 2
• a demand for a reasonable degree of assurance in
transacting with financial firms;
• past experience of bad behaviour by financial firms;
• the value of a contract can be influenced by the
behaviour and solvency of a financial firm after the
contract is signed and product purchased;
• the consumer may be making a substantial
commitment in financial transactions;
• a preference for regulation to prevent hazardous
behaviour by financial institutions as an alternative
to claiming redress after bad behaviour has
occurred; and
• to secure economies of scale in monitoring.
If there is a rational consumer demand for regulatory
services, the consumer would be willing to pay for
them and it is economic to supply them. Regulatory
agencies can be viewed as supplying regulatory,
monitoring and supervisory services to various
stakeholders: financial firms, consumers, government,
etc. Unlike most other goods and services, they are not
supplied through a market process, but are largely
imposed by the regulator, although there may be a
process of consultation. This leads to problems:
valuable information is lost about what type and extent
of regulation consumers demand, and about how much
consumers are prepared to pay for regulation.
Consumers are not homogeneous, and yet their
different demands cannot be signalled through a
market process. Above all, regulation is largely
perceived as being a free good as, in the absence of a
market for regulation, no market price is generated.
Therefore the costs of regulation are not dead-
weight costs. However, there is a major limitation in
that the consumer may have an illusion that
regulation is a costless or free good, in which case the
demand is distorted.
If the perception that regulation is costless is
combined with risk-averse regulators, there is a danger
that regulation could become over-demanded by
consumers and over-supplied by regulators.
15
2.6 The “gridlock” problem
There are circumstances when, without the
intervention of a regulator, a “gridlock” can emerge.
This can arise when firms know how they should
behave towards customers, but nevertheless adopt
hazardous strategies because they can achieve short-
term advantages and they believe that competitors may
also behave hazardously. The detection of hazardous
behaviour may occur only in the long run. In such a
situation two problems can emerge: adverse selection
and moral hazard. In the former, good firms may be
driven out of business by bad firms as the latter
undercut the former. A firm that behaves better
towards its customers than others, and at a cost to
itself, may not be able to distinguish itself from others
and gain additional business. The moral hazard danger
is that good firms may be induced to behave badly
either because they see bad behaviour in others, or
have no assurance that competitors will behave well.
A role for regulation is to set common minimum
standards that all firms know will be applied equally to
all competitors. Regulation can have the positive and
beneficial effect of breaking a gridlock by offering a
guarantee that all participants will behave in
accordance with certain standards.
2.7 Moral hazard
The moral hazard rationale for regulation is linked to
safety net arrangements: deposit insurance and lender
of last resort. Deposit insurance or protection,
applicable mainly to banks, creates five potential
moral hazards:
• Consumers may be less careful in the selection of
banks and may even seek high-risk institutions on
the grounds that, if the bank does not fail they will
receive the higher rates of interest on offer, and if it
does fail they will receive compensation.
• The financial firm may be induced to take more
risks because depositors are protected in the event
that the institution fails.
• Risk is subsidised in that, because of insurance,
depositors do not demand an appropriate risk
premium in their deposit interest rates.
16
• Poorly managed banks are effectively subsidised
by well-managed banks.
• The existence of deposit insurance may induce
banks to hold lower levels of capital.
Likewise, the existence of a lender of last resort can
have adverse incentive effects and induce banks to
take excessive risks.
With or without formal deposit insurance, ultimately
governments protect depositors. This seems to be a
fact of life, and no amount of theorising about the
hazards involved in this is likely to change the
situation. Once implemented, there is little political
feasibility that deposit insurance will be removed and
so, for purposes of analysis, it is taken as given. This
significant revealed preference is questioned because
governments do not use insurance to protect
consumers from the failure of non-financial firms.
In the wider financial sector there may also be moral
hazards in other forms of consumer compensation
arrangements, such as the UK Investors’
Compensation Scheme (ICS):
• Their knowledge of such a compensation facility
may induce some consumers to take less care and
may, under some circumstances, even induce
consumers to gravitate to risky suppliers on the
grounds of a one-way option – if the contract
performs well the consumer keeps the gains,
whereas if the firm becomes insolvent the
consumer is compensated
• The costs of compensation are sometimes
transferred to others who are not part of the
contract. For instance, in the UK, if a financial
adviser becomes insolvent and is unable to pay
compensation, the financial industry as a whole is
required to make payments to the ICS. The moral
hazard is that behaviour may be adversely affected
because the risks can to some extent be passed on
to others.
Overall, the moral hazard is that, when safety net
arrangements are in place, financial firms are able, to
some extent, to pass on risks to others, and this may
adversely affect their behaviour.
The moral hazard rationale for regulation is that
Financial Regulation in South Africa: Chapter 2
regulation can be constructed so as to reduce the
probability that the moral hazard involved with
insurance and compensation schemes will be
exploited. Moral hazard exists with virtually all
insurance contracts (behaviour is likely to change in a
way that increases the probability of the insured risk
materialising) and private market insurance companies
usually take measures to limit the ability of the insured
to exploit it. This may take the form of prescriptions to
influence the behaviour of the insured.
3. Hazards in regulation
Some potentially serious and economically costly
hazards in regulation apply to all sectors of finance
(bank and non-bank financial services), whereas others
apply more specifically to non-banking. Those that
apply generally include-
• the potential for regulators to be captured, i.e. lose
their independence – especially in the case of self-
regulation;
• the impairment of competition and free market
forces;
• the extension of regulation because of conflicts and
contradictions in regulation;
• an asymmetric valuation of the benefits of
competition and regulation by risk-averse
regulators; and
• the danger that regulation may have perverse
effects.
Three particular hazards apply to the regulation of
non-banking services:
• The potential for self-regulatory professions to raise
members’ income by imposing barriers to entry;
• the setting of minimum standards which are
detrimental to the welfare of consumers who would
otherwise choose to purchase cheap and low-
quality services and result in an over-investment in
training and the provision of high-quality services;
and
• “implicit contracts” between consumers and
regulators (see Box 2.4).
4. Objectives, intermediate goals
and targets of regulation
To facilitate the management of objectives as well as
ease of presentation, the objectives of regulation
(Section 4.1) are broken down into intermediate
goals (Section 4.2) and then into regulatory targets
(Section 4.3).
The ultimate objectives are of a broad and
conceptual nature, whereas the intermediate goals
derived from each objective are more manageable,
practical and cover a specific aspect of the broad
objective. For example, the regulators’ ultimate
objective of institutional safety and soundness can be
transformed into a few more specific intermediate
goals. One such intermediate goal is a proper financial
institutional infrastructure. Each of these intermediate
goals is in turn broken down into quantifiable and
measurable regulatory targets. For the
abovementioned intermediate goal, one of those
targets is adherence to minimum capital standards.
The regulatory targets can be broken down into much
more detail (e.g. capitalisation can be split into the
various risk categories such as capital adequacy for
market and credit risks), but this publication is aimed

Box 2.4: Implicit contracts

When a regulatory or supervisory authority is created and it establishes regulatory requirements, there is a danger
that an implicit contract may be created between the user of financial services and the regulator. This arises when
the consumer assumes that, because there is an authorised procedure, specific aspects of regulation have been
established and that the supplier of financial services is in some sense authorised and supervised, and that
therefore the institution is safe. The obvious danger is that an implicit contract creates the impression that
consumers need not take care regarding the firms with which they deal in the area of financial services. This
becomes a further moral hazard of regulation, a hazard where regulation itself creates the impression that less care
need be taken. Should this occur, it would be counterproductive and one of the worse outcomes of regulation.

Financial Regulation in South Africa: Chapter 2 17

at the strategic level. The regulatory targets outlined
can be made operational by transforming them into
quantifiable yardsticks.
4.1 Objectives of regulation
The objectives of financial regulation in the context of
the philosophy and principles are discussed in Chapter 1,
Section 3. To summarise, the objectives are threefold,
namely to sustain –
• systemic stability;
• the safety and soundness of financial institutions;
and
• consumer protection.
Regulation should not be overloaded by being
required to achieve other and wider objectives. This is
discussed further in a later chapter.
4.2 Intermediate goals of regulation
Each of the ultimate objectives can be broken down
into various intermediate goals, as discussed in greater
detail below.
4.2.1 The intermediate goals of systemic
stability
The intermediate goals for achieving systemic stability
can be classified under the following headings:
Competitive market infrastructure
The financial system and markets reach a stage of
development where sufficient information is available
to allow both domestic and foreign participants to
undertake borrowing, lending, trading and the
concluding of obligations rapidly, at known and
acceptable risks and on a level regulatory playing field.
Acceptable maturity and currency
mismatches
The level of systemic risk management is such that the
maturity mismatches of loans and currencies are
“acceptable” for companies and for the nation at large.
Financial firms use in-house value-at-risk models to
monitor these maturity mismatches. The authorities
monitor the mismatches and the greater the risk taken,
the higher the resulting capital adequacy requirements.
Acceptable cross-market exposures
Government, the central bank and financial institutions
18
(especially banks) are aware of the cross-market and
cross-border exposures on their books and are able to
manage the associated risks.
Sufficient market depth and liquidity
Sufficient liquidity is available from the central bank
and financial institutions (especially banks) to enable
the free operation of the financial system and markets,
especially in times of distress. The market itself is of
sufficient depth to survive the impact of large or panic-
driven transactions.
Securities markets as an alternative to
intermediation
The securities markets reach a stage of development
where they become a major competitor to the banking
industry. This is mainly achieved through
securitisation – i.e. the process that turns loans into
tradable securities. More venture capital, even for
small and micro enterprises, are funded – at least
partially – through the securities markets.
Regulatory effectiveness, efficiency and
economy
The financial system is guarded against demand- or
supply-driven over-regulation because regulation
imposes a range of costs (institutional, compliance and
structural), which are ultimately reflected in the price
of financial services. The authorities avoid regulation
that is “excessive” (in that it exceeds what is needed to
achieve its limited objectives); or that focuses upon
inappropriate objectives; and has a cost that may
exceed the economic costs that regulation is designed
to prevent.
4.2.2 The intermediate goals of institutional
safety and soundness
Irrespective of the systemic aspects arising from
financial institutions that are in difficulty – and the “too-
big-to-fail” dilemma – individual financial institutions
and financial markets should be properly structured
and managed, and be competitive. The ultimate
objective of regulation for safety and soundness of
financial institutions is to reduce the probability of
financial firms becoming insolvent. The insolvency of
financial institutions can be detrimental to consumers
even in the absence of system costs. The intermediate
Financial Regulation in South Africa: Chapter 2
goals achieving institutional safety and soundness can
be classified as follows:
Adequate capital resources
Banks and other financial institutions have adequate
capital as an internal insurance fund to cover risks (e.g.
loan defaults that cannot be externally insured). The
amount of capital held reflects the risk characteristics
of the financial institution.
Proper risk assessment
The major risk components of a financial firm (market
risk, credit risk, liquidity risk, counterparty risk and
operational risk) are properly assessed through the new
capital adequacy regime of the Basel Committee and
backed by sufficient capital. Credit risk is assessed by
a standardised approach that relies on external ratings;
or by an internal rating approach based on portfolio
credit risk models, which provide a more accurate
estimate of credit risk.
Proper financial institutional and market
infrastructure
The infrastructure of financial institutions and markets
is sound and prudent and supported by adequate
national and international technological infrastructure
(e.g. a reliable and secure inter-bank payment and
settlement system).
Suitable (fit and proper) directors and
management
Financial institutions are owned, directed and managed
by competent staff of integrity and follow
internationally recognised business codes.
Global institutional competitiveness
Regulation is closely co-ordinated with governments’
general competition policy to permit financial
institutions to effectively compete domestically and
globally in an intensifyingly competitive environment
and is complicated by the advent of electronic
commerce. The creative tension between the pressures
of competition and regulation is managed to the
benefit of consumers.
It may be noted here that, given the special position
of finance, and the systemic issues that apply, the
question arises about the extent to which the full rigour
of competition policy should be applied in the
Financial Regulation in South Africa: Chapter 2
financial sector (see Box 2.5 overleaf and Boxes 1.1
and 1.2, Chapter 1, Section 3).
Competitive neutrality
Globalisation, the advent of the Internet and electronic
commerce, and the ability to obtain and act on
information rapidly has forced the levelling of playing
fields and removed inappropriate and unwarranted
regulation which could no longer be enforced.
4.2.3 The intermediate goals of consumer
protection
Consumers of financial services and participants in the
financial system should be treated fairly and protected
against unscrupulous or unsound financial institutions.
There is a major difference between wholesale and
retail business in the sense that the requirements for
incorporating the international dimension into
regulation are far greater in the former than the latter.
To a large extent the regulation of retail business can
be left mostly, if not entirely, to purely domestic
jurisdictions where each country can choose its own
regulatory requirements.
It can be argued that, as with other products and
services, the main protection for consumers of
financial services lies in a combination of competition,
information disclosure, reputation and legal redress. At
low cost, consumers can shift their business from
suppliers with doubtful reputations to their competitors
because many firms deliver similar financial products.
Financial firms therefore have strong incentives to
maintain a reputation for honesty and fairness.
However, there are several reasons for being
sceptical about too much reliance on this type of
reasoning: (i) shifting to other suppliers may not
always be a feasible option and some financial
products are not subject to repeat purchase; (ii) it may
be a long time (if at all) before hazardous behaviour or
that an inappropriate or weak product has been
purchased becomes apparent; (iii) the consumer may
not have sufficient information or capability to assess
information, in order to discriminate between
alternative suppliers; and (iv) in practice the nature of
many long-term financial contracts is such that there
may be heavy penalties when existing contracts are
19
cancelled ahead of maturity (because it is common for
the total costs of the contract to be deducted from
premiums paid in the first or early years). In summary,
the consumer is left with the problem of being unable
to distinguish between good and bad suppliers of long-
term contracts.
In some countries there are examples suggesting that
complete reliance cannot be placed on free competition
and reputation to offer an acceptable degree of
consumer protection in retail financial services. There
have been several costly scandals over the past two
decades, e.g. consumer confidence in the integrity of
financial firms has often been low; financial firms
strongly resist the disclosure of even basic information
until mandatory disclosure is imposed; inadequate
compliance with business conduct requirements (see
Box 2.6); in addition substantial amounts of
compensation have been paid to consumers.
Reputation, competition and information disclosure
are necessary ingredients of consumer protection. The
question is whether they are sufficient ingredients. It
would appear that the consumer cannot rely upon the
reputation of financial institutions in all cases. It may
be that the reputation effect is too diffuse in long-term
contracts, because it may take a long time before any
fault or misrepresentation is detected. In fact, this may

Box 2.5: Competition

Although the consumer desires the benefits of both competition and regulation, in practice regulation is in part
inevitably designed to limit the alleged excesses of competition. In the past, a lot of regulation has had the effect
of moderating competitive pressures on the premise that “excessive competition” has the effect of increasing
risk – the dilemma is that competition can add to the risk of failure, whereas attempts at avoiding such risk through
regulation often have the effect of reducing competition.
Competition policy in regard to financial institutions varies considerably between countries and in some the
issue is by no means settled. Regulation does not replace competition. Regulation, if properly constructed,
reinforces the efficiency of, rather than detracts from, market mechanisms, i.e. it does not impede competition but
enhances it and, by addressing information asymmetries, make it more effective in the marketplace. Nevertheless,
however well-intentioned, regulation has the potential to compromise competition and to condone, if not in some
cases endorse, unwarranted entry barriers, restrictive practices and other anti-competitive mechanisms. Although
regulation in finance has historically often been anti-competitive, this is not an inherent property of regulation. As
there are clear consumer benefits and efficiency gains to be secured through competition, regulation should not
be constructed in a way that impairs it. Regulation and competition need not be in conflict – on the contrary, if
properly constructed they are complementary. Regulation can also make competition more effective in the
marketplace by, for instance, requiring the disclosure of relevant information that can be used by consumers in
making informed choices. It is often argued that regulation and competition are in conflict, and that regulation
impedes competition. In many respects, regulation versus competition is a false dichotomy:
• Properly constructed, regulation has the potential to enhance competition;
• disclosure requirements enhance price competition whereas, traditionally, competition in the life assurance
industry has operated via raising costs (e.g. competition in delivery mechanisms);
• disclosure in all its various forms widens the dimensions in which competition operates, so there are more
areas in which competition operates (e.g. contract terms);
• firms are likely to emphasise the competence of their staff and this is likely to develop as part of a competitive
strategy;
• disclosure enables the media and financial advisers to focus on the terms offered in contracts by various
suppliers of contracts;
• disclosure is also likely to lead to an unbundling of contracts with the result that there will be increased
competition in the various characteristics of contracts; and
• given public perceptions, competition could develop in compliance standards.

20 Financial Regulation in South Africa: Chapter 2

never come to light. The problem is compounded
when salespeople are remunerated on the basis of
commission, and when movements between
companies are high.
Given this background to consumer protection, the
following intermediate goals can be established:
Integrity and fairness
Effective and efficient regulation addresses the
problems of failed contracts and reduces the
probability of them occurring.
There are five alternative dimensions to a failed
contract: (i) the consumer receives bad advice –
perhaps because an agency conflict is exploited; (ii)
the supplying institution becomes insolvent before the
contract matures; (iii) the contract turns out to be
different from what the consumer was anticipating;
(iv) fraud and misrepresentation; and (v) the financial
institution has been incompetent.
Competence
Suitability and “fit and proper” standards are
implemented for directors, management, staff and for
the compliance office – the external auditors and
regulators audit the quality of the compliance office to
ensure these guardians fulfil standards themselves.
Providers of financial services and products –
traditional financial institutions and new entrants – are
encouraged to compete freely in the provision of such
services and products.
Effective competition is the major component of
consumer protection and the assurance of good
products at competitive prices. The purpose of
regulation is, therefore, not to displace competitive
pressures or market mechanisms, but to correct for
market imperfections and failures, which produce
suboptimum outcomes and distort consumer choice.
To the extent that regulation enhances competition
and, through this, efficiency in the industry, it creates a
set of markets that work more efficiently and through
which consumers gain (see Box 2.5).
Transparency and disclosure
Adequate information is available about financial
services and products and the firms which provide
them. The disclosure of relevant information is an
essential ingredient of consumer protection. The
question of whether disclosure should be mandatory,
or voluntary is addressed.
It may be noted that in some countries, investment
and insurance companies have strongly resisted a
disclosure of companies’ costs which meant that
consumers were unaware of the full costs of financial
products, e.g. life assurance and personal pensions.
There are three main arguments in favour of
mandatory disclosure requirements:
• It would ease comparison between alternative
products, and hence lower consumers’ transactions
costs, if disclosure is made on the same basis by all
firms;
• standardised information could help consumers
make choices – in this sense, mandatory disclosure
would have a positive externality; and
• the consumer is often uncertain about what is the
relevant information that should be demanded
when complex products are involved.
Regulators do not know what information
consumers require as, in some cases, what is relevant
is specific to the individual. Mandatory disclosure sets
out minimum disclosure requirements on a consistent
and standardised basis that all firms must adhere to for

Box 2.6: Non-compliance

A 1997 report by the UK Financial Services Authority (FSA) following an investigation of one of the country’s
largest insurance and life assurance companies found as follows: “a deep-seated and long-standing failure in
management”, and “a cultural disposition against compliance that filtered through [the firm’s] branch offices, their
managers and advisers.” The FSA found “continuing and persistent breaches across major areas of its business”.
The report also suggests that the company had: “an organisation structure which allowed the cost of its own
compliance arrangements to take precedence over the interests of its investors.” A public reprimand was given
and the company voluntarily withdrew its entire sales force for retraining.

Financial Regulation in South Africa: Chapter 2 21

all retail customers. This does not preclude giving
additional information. Information imbalances were
found in the UK, see Box 2.7.
Adequate access to retail financial services
Consumers have adequate access to financial firms,
products and services without discrimination. Such
access is by means of a variety of traditional and
electronic access and delivery mechanisms available
from financial institutions or their agents.
Protection of retail funds
The funds invested by retail investors in financial
institutions are protected in case the firm fails.
Retail compensation schemes
The market conduct of financial firms is vested in one
single specialist regulator for all market conduct
issues. Compensation procedures are established in
terms of which the client can complain about a wrong
action on the part of the firm and is compensated
immediately; and failing this the client can take his
case to the ombudsman or adjudicator who will
reconsider the case.
4.3 Targets of regulation
Where the intermediate goals of regulation are in
essence a transformation of the regulatory principles,
the regulatory targets are empirically falsifiable
magnitudes in the sense that they can be either missed
or dismissed.
Targets can seem very similar to instruments if they
are broken down into finer detail. However, although
they seem similar, they differ conceptually. For
instance, to strive for internationally acceptable
accounting standards is clearly a regulatory target, but
it is through monitoring and supervision (as a type of
regulatory instrument) that this target is ultimately
met. Alternatively stated, as an instrument of financial
regulation, monitoring and supervision can be
executed in terms of various minimum standards, one
of them being internationally acceptable accounting
standards. However, other instruments – such as
enforceable compliance structures in the private sector
or detailed external audit requirements – could also be
used to implement this specific accounting standard.
In short, targets are typically specific ratios, models,
codes, manuals, systems or standards, which can be
either approved or rejected by the authorities.
Examples of regulatory targets are a specific capital
ratio, a specific value-at-risk model, a compliance
manual, a code of business conduct, a specific trading
system or an accounting standard.
Over time the regulatory targets are bound to change
in line with the changing philosophy underpinning the
regulatory regime of the nation. Tables 2.1, 2.2 and 2.3
give an overview of the various targets identified that
could be aimed at by the regulatory authorities in
South Africa. In Chapter 7, Section 3 most of these
targets and their applicability to the regulatory regime
are discussed in greater detail.

Box 2.7: Asymmetric information

In a recent report, the UK Consumers Association (1998) argues as follows:
“The information imbalance that has arisen between the consumer and industry has enabled the sale of
substandard products which has, in many cases, cost the consumer (and the taxpayer) dear. For example, in the
personal pensions mis-selling saga, hundreds of thousands of consumers fell victim to disgraceful sales practices
and poor advice ... Personal pensions and life products such as endowment plans can pose particular problems
because of the hidden penalties for switching, inflexibility and high charges. In many cases it is next to impossible for
consumers to work out exactly what the charges are because of the euphemisms and obscure language used to
disguise charges. All this has meant that there is no real competition in these markets. The lack of transparency
means consumers have been unable to compare products, shop around and so in turn exert competitive pressure.”

22 Financial Regulation in South Africa: Chapter 2

 Table 2.1: Intermediate goals and targets supporting systemic stability
1. Competitive market infrastructure
• Establish a payments system that is open to all financial institutions
• Promote competitive trading, clearing and settlement systems
• Promote competitive listing requirements
• Stipulate minimum infrastructure standards
• Establish interrelated and competitive markets
• Establish regulatory neutrality towards foreign participants
2. Acceptable maturity and currency mismatches
• Promote accurate value-at-risk systems
• Promote management of forward currency book by the private sector
• Promote prudential debt-management systems in the public sector
3. Acceptable cross-market exposures
• Establish cross-market clearing and settlement facilities
• Establish legally binding netting agreements between markets
4. Sufficient market liquidity
• Establish a financial stability unit at the central bank
• Formalise the standby facilities of the central bank
• Remove (tax) constraints on market turnover
• Promote foreign participation in local markets
5. Securities markets as alternative to finance intermediation
• Remove constraints on commercial paper issues from banking legislation
• Establish a market in the bonds of SMMEs
6. Regulatory effectiveness, efficiency and economy
• Establish co-ordination agreements among domestic regulatory agencies (complex groups)
• Establish harmonisation agreements between home and host regulators (complex groups and highly
geared non-financial institutions)
• Stipulate regulatory cost/benefit analysis
• Establish ratings of national regulatory agencies

Financial Regulation in South Africa: Chapter 2 23

 Table 2.2: Intermediate goals and targets supporting institutional safety and soundness
1. Proper risk assessment
• Promote accurate value-at-risk systems
• Stipulate consolidated supervision
• Appoint specific non-executive board members to supervise risk management and management systems
• Appoint accredited private rating agencies
• Promote unsecured subordinated debt as a rating tool
2. Proper financial institutional infrastructure
• Adhere to minimum accounting and audit standards
• Adhere to minimum capital standards
• Adhere to corporate governance standards
• Adhere to compliance standards
• Establish an infrastructure for the verification of firms’ risk and control systems
• Establish an industry register of doubtful and bad debts
3. Suitable directors and staff
• Stipulate specific minimum suitability standards for directors and senior management
• Stipulate entry requirements for technical staff
• Link remuneration packages to compliance standards
4. Global institutional competitiveness
• Abolish foreign exchange controls
• Remove regulatory limitations on e-commerce and e-money
• Remove regulatory limitations on foreign firms
• Allow remote trading
• Allow international listings
5. Competitive neutrality
• Adhere to international agreements on regulatory minimum standards
• Encourage functional approach to regulation
• Encourage competitive neutrality between commerce and e-commerce

24 Financial Regulation in South Africa: Chapter 2

 Table 2.3: Intermediate goals and targets supporting consumer protection
1. Integrity and fairness
• Encourage a code of corporate governance
• Encourage a code of business conduct
• Establish a policy to reduce financial crime and money laundering
• Encourage effective compliance manuals
2. Competence
• Stipulate “fit and proper” standards for compliance office
3. Adequate product/service competitiveness
• Remove constraints on competitive foreign products
• Remove regulatory exclusions granted to parastatals or public corporations
4. Transparency and disclosure
• Adhere to international codes of corporate governance
• Adhere to international codes of disclosure standards
• Establish government-defined benchmarks for better consumer information
• Inform the financial press
• Supply of competitive information on Internet by authorities
5. Adequate access to retail financial services
• Establish core banks in retail trading sector
• Open the payments system to non-bank financial institutions
6. Protection of retail funds
• Establish Structured Early Intervention and Resolution regime
• Limit the use of retail investment funds as an instrument of social engineering
• Stipulate acceptable operational risk-management systems
7. Retail compensation schemes
• Stipulate ombudsmen arrangements
• Stipulate fidelity fund arrangements
• Establish bank deposit-insurance scheme
• Establish a single regulator for all market-conduct rulings

Financial Regulation in South Africa: Chapter 2 25

 Chapter 3
THE REGULATORY REGIME
1. Introduction
Essentially, regulation is about changing the behaviour
of regulated institutions. Regulation can be
endogenous inside the financial firm as well as
exogenous. A major issue, therefore, is whether
regulation should proceed through externally imposed,
prescriptive and detailed rules, or by the regulators
creating incentives for appropriate behaviour.
A robust financial system requires three particular
properties: (i) proper decision making and control
within financial institutions with effective risk
analysis, as well as management and control systems;
(ii) an efficient regulatory and supervisory regime for
financial institutions; and (iii) sound incentive
structures for all parties, including regulators.
This chapter considers various alternative
approaches to achieving the objectives of financial
regulation falling under the concept of a regulatory
regime, which is far wider than the rules and
monitoring conducted by regulatory agencies. The
focus will be on how the components of a regulatory
regime are to be combined to produce an optimum
regulatory strategy for achieving regulatory objectives
as opposed to particular ways of addressing specific
regulatory problems.
Chapter 4 develops the regulatory regime into a
regulatory strategy framework based on the target-
instrument approach.
2. Alternative approaches
Financial systems are changing substantially to an
extent that may undermine traditional approaches to
regulation, particularly to the balance between
regulation and supervision, and the role of market
discipline. The following issues are of particular
importance:
• The strong impact of globalisation on local firms;
26
• the pace of financial innovation and the creation of
new financial instruments;
• the blurring of traditional distinctions between
different types of financial firm;
• the speed with which portfolios can change through
trading in derivatives; and
• the increased complexity of banking business.
All of the above factors create a fundamentally
new – in particular, more competitive – environment
in which regulation and supervision are undertaken.
These factors also change the viability of different
approaches to regulation which, if it is to be effective,
must constantly respond to changes in the market
environment in which regulated firms operate.
Three observations are made at the outset of the
analysis and which inform the analysis that follows:
• The elements of the economic rationale for
regulation (discussed in Chapter 2) are relevant to a
consideration of the focus of this chapter – i.e. the
optimum regulatory strategy. In particular,
regulation needs to be framed around, and justified
in terms of, issues such as market imperfections, as
such issues are the foundation for an economic
rationale for regulation.
• The existence of an economic rationale for
regulation and a consumer demand for it do not
justify everything that the regulator does.
• The case for regulation in no way excludes a
significant role for other mechanisms so as to
achieve the desired objectives of systemic stability,
institutional safety and soundness, and legitimate
but limited consumer protection.
The central theme of this chapter is that the various
components of the regulatory regime need to be
combined and balanced, and that though all are
necessary, none alone are sufficient. Regulation,
therefore, is not an alternative to, for instance, market
discipline, but a complement to it. Indeed, a key issue
Financial Regulation in South Africa: Chapter 3
to consider is the potential danger that regulation
could, under some circumstances, blunt the application
of other mechanisms.
Internationally there is a definite shift within the
regulatory regime to maximise its overall effectiveness
and efficiency in the following ways:
• Less emphasis is being given to formal and
detailed prescriptive rules dictating the behaviour
of regulated firms.
• A greater focus is being given to incentive
structures within regulated firms and to determining
how regulation might have a beneficial impact on
incentive structures.
• The view is that market monitoring and market
discipline of financial firms should be strengthened
within the overall regulatory regime.
• There is a growing recognition of the need for
greater differentiation between regulated firms,
different types of consumers and different types of
financial business.
• Greater emphasis is being placed on internal risk
analysis, management and control systems. Externally
imposed regulation in the form of prescriptive and
detailed rules is becoming increasingly inappropriate
and ineffective. More reliance should be placed on
institutions’ own internal risk analysis, management
and control systems. This relates not only to
quantitative techniques such as value-at-risk (VaR)
models, but also to the management and compliance
“culture” of those who handle models and supervise.
There should be a shift of emphasis towards
monitoring risk-control mechanisms, and a recasting
of the nature and functions of external regulation
away from generalised rule-setting towards
establishing incentives and sanctions to reinforce such
internal control systems.1
1
For instance, the recently issued consultative document by the
Basel Committee on Banking Supervision (Basel Committee,
1999) explicitly recognises that a major role of the supervisory
process is to monitor banks’ own internal capital management
processes and “the setting of targets for capital that are
commensurate with the bank’s particular risk profile and control
environment. This process would be subject to supervisory review
and intervention, where appropriate”.
Financial Regulation in South Africa: Chapter 3
• It is recognised that corporate governance
mechanisms for financial firms need to be
strengthened so that, for instance, owners would
play a greater role in the monitoring and control of
firms, and compliance issues would be identified as
the ultimate responsibility of a nominated director
of the main board.
All of these, and other trends, are reflected in the
recent Basel consultation document on new
approaches to capital adequacy regulation of banks.
As a simplification, there are two alternative
approaches to regulation. At one end of the spectrum
the regulator lays down fairly precise regulatory
requirements that are applied to all regulated firms.
There may be limited differentiations within the rules,
but the presumption is for a high degree of uniformity.
At the other end of the spectrum is what is termed
contract regulation. Under this regime, the regulator
sets down a clear set of objectives and general
principles. It is then for each regulated firm to
demonstrate to the regulator how these objectives and
principles are to be satisfied by its own chosen
procedures. In effect, the regulated firm self-selects its
own regulation but within the strict constraints of the
objectives and principles laid down by the regulator.
Once the regulator has agreed with each firm how the
objectives and principles are to be satisfied, a contract
exists between the regulator and the regulated firm. The
contract requires the firm to deliver on its agreed
standards and procedures. In the case of non-
performance on the contract, sanctions would apply and
the regulator would have the option of withdrawing the
choice from the regulated firm (which would then have
to accept a standard contract devised by the regulator).
The advantage of this approach is that a regulated firm
would be able to minimise its own costs of regulation
by submitting to the regulator a plan that, while fully
satisfying the requirements of the regulator, would best
suit its own particular circumstances.
The case for regulation, discussed earlier (Chapter 2,
Section 2), does not mean that official regulation is to
be the exclusive route through which the objectives set
for regulation are met, or to imply that reliance can be
27
placed on it. On the contrary, regulation should be
viewed as part of a collective regulatory strategy.
Such a strategy would include official supervision,
incentive structures, market discipline, rules for
intervention, corporate governance arrangements and
disciplining mechanisms on regulatory agencies. This
is the essence of the regulatory regime and is discussed
in greater detail below.
Even within the purely regulation component of a
broader regulatory strategy, there is a wide range of
options available, and in particularly with respect to the
degree of discretion exercised by the regulatory agency.
When considering this wider perspective of
regulation, six themes in particular emerge and need to
be emphasised:
• Regulation needs to be viewed and analysed not
solely in the narrow terms of the rules, regulations
and edicts of regulatory agencies, but in the wider
context of a regulatory regime. The concept of a
regulatory regime has seven components:
(i) The rules and regulations established by
regulatory agencies – the pure regulation
component;
(ii) official monitoring and supervision by
regulatory agencies;
(iii) intervention arrangements in the event of
there being compliance failures of one sort or
another;
(iv) the incentive structures and contracts faced
by regulatory agencies, consumers and, more
particularly, by regulated firms;
(v) the role of market discipline and monitoring;
(vi) the role of corporate governance arrangements
in financial firms; and
(vii) the disciplining and accountability arrange-
ments applied to regulatory agencies.
• A regulatory strategy to achieve the objectives set
for regulation should not be restricted to a view of
what rules and supervision are established by a
regulatory agency. A regulatory strategy is about
optimising the combination of the seven
components of the regime. The strategy also needs
to be considered in the context that there are often
28
trade-offs to be made within the range and between
the components in order to maximise the overall
impact. In some circumstances the greater the
emphasis on one of the components, the weaker the
power of one or more of the others, even to the
extent of perhaps reducing the overall impact.
Equally, different combinations of the components
may achieve the same degree of effectiveness in
meeting the objectives but at different costs. The
possibility needs to be considered that if more
emphasis is given to detailed, extensive and
prescriptive rules, this might weaken the role of
incentive structures, market discipline and
corporate governance. In other words, rules may
weaken incentive structures and market discipline.
• Public (and particularly academic) debate about
regulation is often too polarised with too many
dichotomies established – what are often posed as
alternative approaches are in fact not alternatives
but complementary mechanisms. It is emphasised
that the skill in formulating regulatory strategy is
not so much in choosing between the various
options, but in combining the seven key
components of the regulatory regime. The skill of
the regulator in devising a regulatory strategy lies
in how the various components in the regime are
combined, and how the various instruments
available to the regulator are used (these are listed
in Section 4 below), including their potential
impact on other components of the regime. So,
although there may be negative trade-offs to
consider, the relationship between the components
of the regime may also be positive in that, for
instance, regulation could itself focus on creating
appropriate incentives within regulated firms.
Therefore, it is not a question of choosing between
either regulation or market discipline, or between
regulation and supervision on the one hand and
competition on the other. The concept of a
regulatory strategy discussed here is that the above
are not to be viewed as alternatives but components
of an overall approach to achieving the objectives
that are set for regulation. A key issue for the
Financial Regulation in South Africa: Chapter 3
 regulator to consider is how its actions not only
contribute to the objectives directly, but how they
impact on the other components of the regime.
More particularly, the issue is how regulation
affects incentive structures within firms and also
the role that can be played by market monitoring
and discipline.
• The optimum mix of components within the
regulatory regime will change over time as market
conditions and structures and hence the regulatory
philosophy change. It is argued that, in current
conditions, there needs to be a shift in the structure
of the current strategy in some respects: (i) less
reliance should be placed on detailed and
prescriptive rules, and more emphasis should be
given to the other components (most especially
market discipline); and (ii) official supervision
should focus more on incentive structures, an
enhanced and strengthened role for market
discipline and monitoring (in ways which will be
outlined below), and a more central role for
corporate governance arrangements within
financial firms.
• Consumers, financial firms and different types of
financial business are not homogeneous, which
means that the optimum regulatory approach is
likely to differ for different consumers, financial
firms and financial business. This has been
recognised by the regulatory authorities in some
countries. However, it is argued that there should
be more differentiation. One approach that should
be considered is contract regulation, as outlined
above. In effect, what is involved here is a regime
of self-selecting regulatory contracts.
• Given the power and discretion that the regulatory
agencies have, their own accountability and
disciplining mechanisms need to be constantly
emphasised.
When considering the above theme, the importance
of trade-offs within the regulatory regime should be
emphasised. In terms of regulatory strategy, a choice is
to be made about the balance of the various
components and the relative weight to be assigned to
Financial Regulation in South Africa: Chapter 3
each. In this way, a powerful role for official
regulation may be chosen with little weight assigned to
market discipline, or a relatively light touch of
regulation but with heavy reliance on the other
components. A given degree of investor protection can
be provided by different combinations of rules,
supervision, market discipline, etc. and with various
degrees of discretion applied by the regulator. For
example, the same level of investor protection could
be provided by combining a highly detailed and
prescriptive rulebook and a small degree of
supervisory discretion, or by combining a set of
general principles and a high degree of supervisory
discretion in how those principles are to be translated
into action by regulated firms. The second form of
trade-off is more causal in nature and relates to how
the components of the regime may be causally and
negatively related. For example, heavy reliance on
formal regulation of a highly prescriptive nature may
weaken incentives, erode market monitoring and
discipline, and may have adverse effects on corporate
governance arrangements.
In essence, in a market that is heavily regulated for
internal standards of integrity, the incentives for fair
dealing diminish. Within the company culture, such
norms of fair dealing as “it’s the way we do things
around here” would eventually be replaced by “it’s OK
if we can get away with it”.
The key to optimising the effectiveness of a regulatory
regime is the portfolio mix of the seven core
components. To reiterate, all components are necessary
but none alone are sufficient. Particular emphasis is
given to incentive structures because, at the end of the
day, if these are perverse or inefficient, no amount of
formal regulation will prevent problems from emerging.
The mix will change over time. It might be argued
that the regulation of retail investment business has in
many countries been highly prescriptive and detailed.
It might also be argued that, given past experience
and the various scandals that had been exposed, this
was necessary at the outset in order to “shock” the
industry into a more compliant approach to its
business and the way it conducts business with
29
potentially vulnerable investors. If the norms and
compliance culture of the industry change, it might
become appropriate to rely less on detailed and
prescriptive regulation, as far as some firms are
concerned (see Box 3.1). The UK Personal
Investment Authority’s (PIA) Evolution Project was
designed to consider how regulatory strategy might
be modified in the light of changing circumstances.
Neither does it follow that the same approach and
mix of components in the regulatory regime should be
the same for all regulated firms, all consumers or all
types of business or markets. On the contrary, given
that these are not homogeneous, it would be
suboptimum to apply the same approach. The key
strategic issue is the extent to which variations are
made between different consumers, regulated firms
and business areas. However, in most countries it is
argued that more differentiation is warranted than is
currently allowed for.
In summary, the above amounts to emphasising an
overall regulatory strategy rather than focusing on
regulation per se. The central theme is that rules and
regulations are an important, but only one, component
of a regulatory regime designed to achieve the
objectives of systemic stability, institutional safety and
soundness, and consumer protection in finance. Giving
too much emphasis in public debate to regulation per
se has the danger of minimising the crucial importance
of the other components, and most especially the role
of market discipline.
As part of its commitment to a flexible and
differentiated approach, and the need to minimise the
costs of regulation, it is to be hoped that regulators will
explore how differentiated approaches and elements of
choice can be extended to all areas of regulation,
including the area of conduct of business. An
additional advantage of allowing an element of
monitored choice is that more is learnt about what

Box 3.1: Compliance culture

The compliance culture within regulated firms is crucial to the success of a regulatory strategy. The regulator can
have a major impact on culture through its actions and the incentives it creates. This aspect also limits how far
regulatory measures which are specific to cost-benefit analysis can go in determining the ultimate value of
regulation. Consequently, the main benefit may derive, not from how regulatory measure X impacts on benefit Y, but
from how regulation itself enhances consumer benefits through a more general impact on the culture of the industry.
Suppose an improvement is observed in consumer welfare derived through purchasing financial products. This
could have been achieved through one of five ways: (i) specific regulatory rules have successfully addressed
specific problems (e.g. disclosure); (ii) consumers have become more aware and more conscious of some of the
potential hazards when buying complex financial products; (iii) consumers have become more sophisticated and
have a greater understanding of the questions to ask, the comparisons to be made and better understand financial
issues; (iv) market conditions (e.g. competition) have improved; or (v) a generally, and diffused, improved culture
of compliance and competence in the industry. However, it is only in case (i) above that cost-benefit analysis
(CBA) can effectively be applied even though regulation may have contributed to each of the other four.
Ultimately, the general culture and standards of the industry may be a more significant to consumer benefit than
the impact of specific measures. However, this will not be picked up through CBA. Put another way, the total
impact of regulation may be greater than the sum of its parts. This is not intended to argue against the application
of cost-benefit analysis, and other measures of effectiveness, to regulatory measures – this is always desirable.
However, the limitations need to be recognised.
Compliance culture is not a phenomenon restricted to finance. An example in a different area illustrates the
point. Ten years ago a smoker would not feel uncomfortable about lighting a cigarette at a host’s dinner party
without seeking permission. Five years ago the smoker would have asked permission. Today, if the host does not
smoke, it is almost inconceivable that the guest would even consider asking permission. This is not because there
is any specific regulation preventing smoking in friends’ houses, but because the culture has changed after the
general message that smoking is anti-social.

30 Financial Regulation in South Africa: Chapter 3

determines good regulation. Part of the learning
process is lost when a monopolist regulator imposes a
uniform set of requirements.
3. The components and instruments
of the regulatory regime
A regulatory agency has a range of instruments
available to it: rules and regulations, authorisation,
mandatory disclosure requirements, creating
appropriate incentives, establishing principles and
guidance, monitoring, intervention, sanctions and
compensation. A key choice for any financial
regulator, as with any policy maker with multiple
objectives, is the selection from the various
instruments available in the regulatory regime, and the
way they are combined to achieve the broad set of
objectives. To reiterate, the skill lies not so much in
the choice of instruments, but in how they are
combined in the overall strategy mix. It is not a
question, for instance, of rules versus market
discipline, but how the full range of instruments is
used to create an overall effect. The various
instruments can be used in a variety of combinations,
and with various degrees of intensity.
As already noted, the key components of a
regulatory regime are as follows:
• Rules and regulations
• Official monitoring and supervision
• Intervention and sanctions
• Incentive contracts and structures
• Market monitoring and discipline
• Corporate governance
• Discipline on, and accountability of the regulators
These components of the regulatory regime are
discussed in more detail below. The following sections
(3.1–3.6) discuss each of the components in turn.
3.1 Rules and regulations
In prescriptive legislation, the rules for financial
institutions are laid down in the actual legislation or
by regulatory agencies. This form of regulation has
proved inflexible and is difficult to modify within
an acceptable timeframe. The trend is towards the
Financial Regulation in South Africa: Chapter 3
use of enabling legislation where the power to
formulate rules and regulations is given – with
appropriate safeguards and in consultation with
financial sector participants – to a designated
regulator or “Registrar”. However the regulator is
responsible for the promulgation and enforcement
of the regulations.
One of the roles of regulation is to authorise or
“license” the suppliers of financial services. In this
role there is a case for excluding companies that
cannot or will not meet certain minimum standards of
consumer protection. It is analogous to pollution
regulation, which excludes some firms from an
industry because they cannot afford production
techniques that satisfy pollution standards, or car
manufacturers that cannot meet minimum safety
standards. There need be no difficulty with this
concept of an entry barrier.
Rules and regulations can be described under the
following headings:
• Entry and standards requirements, e.g.
restrictions on the issue of financial instruments, fit
and proper requirements for traders, or the various
entry requirements for a firm, such as minimum
capital and appropriate computer systems.
• Ownership constraints, e.g. whether a firm is
allowed to operate as a financial conglomerate or
as a pyramid holding company.
• Functional activity constraints, e.g. whether the
range of allowable business of an institution is
limited, and whether a firm should have “Chinese
walls” (as in universal banking) or “fire walls” (as
reflected in separately capitalised banking and
securities business subsidiaries).
• Jurisdictional constraints, e.g. whether a firm is
prohibited from operating outside certain
geographical areas.
• Pricing constraints, e.g. whether a firm is
compelled to charge a fixed brokerage.
• Operational constraints, e.g. whether a firm has
to operate within capital and liquidity constraints or
within the constraints set by a code of conduct for
investment business.
31
3.2 Official monitoring and supervision
Because of the nature of financial contracts between
financial firms and their customers2, there is a need for
the continuous monitoring of the behaviour of financial
firms. The question is who is to undertake this
necessary monitoring: customers, shareholders or, for
instance, rating agencies. Because most – especially
retail – customers are not in practice able to undertake
such monitoring, an important role of regulatory
agencies is to monitor the behaviour of financial firms
on behalf of customers. In effect, consumers delegate
the task of monitoring to a regulatory agency, and
hence that agency can be viewed as supplying
monitoring services to the customers of financial firms.
There are strong efficiency reasons for consumers to
delegate monitoring and supervision to a specialist
agency, which can act on their behalf and reduce
transactions costs.
The form and intensity, of supervisory requirements
should differentiate between regulated institutions
according to their relative portfolio risk and the
efficiency of internal control mechanisms. While the
objective of “competitive neutrality” in regulation is
something of a mantra, this is not satisfied if unequal
institutions are treated equally. One of the hazards of a
detailed and prescriptive rulebook approach is that it
may fail to make the necessary distinctions between
non-homogeneous firms because the same rules are
applied to all – i.e. it reduces the scope for making
legitimate differentiations.
3.3 Intervention and sanctions
There needs to be a well-defined strategy for responding
to the possible insolvency of financial institutions. A
response strategy in the event of financial institution
distress has several possible components:
• Being prepared to close insolvent financial
institutions;
2
Including, for instance: potential principal-agent problems; the
quality of a financial product cannot be ascertained at the point of
purchase; the value of a product is determined by the behaviour of
the supplier after products have been purchased and contracts
entered into. See also Box 2.3 in Chapter 2.
32
• taking prompt corrective action to address financial
problems before they reach critical proportions;
• closing unviable institutions promptly, and
vigorously monitoring weak and/or restructured
institutions; and
• undertaking a timely assessment of the full scope
of financial insolvency and the fiscal cost of
resolving the problem.
There should be a clear bias (though not a bar)
against forbearance when a financial institution,
especially a bank, is in difficulty.
Regulatory authorities need to build a reputation for
tough supervision and, when necessary, decisive
action in cases of financial distress. Supervisory
authorities may, from time to time, face substantial
political pressure to delay action in closing hazardous
financial institutions. They may also be induced to
“gamble for resurrection” by allowing an insolvent (or
near-insolvent) institution to make an attempt to trade
out of its difficulty. There is an additional danger of
regulatory capture, and that a risk-averse regulator
may simply delay intervention in order to avoid blame.
The need to maintain credibility creates a strong bias
against forbearance, and a large number of cases of
unsuccessful forbearance reinforces this conclusion.
However, there are circumstances where it is
appropriate to override this general presumption.
Time-inconsistency and credibility problems should
be addressed through precommitments and graduated
responses with the possibility of overrides. In the case
of banks, there is an active debate about rules versus
discretion with respect to intervention in the case of
distressed or insolvent banks – to what extent should
intervention be circumscribed by clearly defined rules
(so that intervention agencies have no discretion about
whether, how and when to act) or should there always
be discretion simply because relevant circumstances
cannot be set out in advance? The danger of discretion
is that it increases the probability of forbearance. A
rules-based approach, by removing any prospect that a
hazardous bank might be treated leniently, also has the
advantage that it enhances the incentives for bank
managers to manage their banks prudently so as to
Financial Regulation in South Africa: Chapter 3
reduce the probability of insolvency. In addition, it
enhances the credibility of the regulator’s threat to
close down institutions.
Many analysts have advocated various forms of
predetermined intervention though a general policy of
Structured Early Intervention and Resolution (SEIR). It
has been argued that SEIR is designed to imitate the
remedial action which private bond holders would
impose on banks in the absence of government
insurance or guarantees. In this sense it is a mimic of
market solutions to troubled banks. An example of the
rules-based approach is to be found in the Prompt
Corrective Action (PCA) rules in the US. These specify
graduated intervention by the regulators with
predetermined responses triggered by capital thresholds.
A major issue for the credibility, and hence
authority, of a regulator is whether rules and decisions
are time-consistent. There may be circumstances
where a rule, or normal policy action, needs to be
suspended. The priors may be that there is a strong
case for precommitment and rules of behaviour for the
regulator. However, there is also a case for a
graduated-response approach since, for example, there
is no magical capital ratio below which an institution
is in danger and above which it is safe. Other things
being equal, potential danger gradually increases as the
capital ratio declines. This in itself suggests that there
should be a graduated series of responses from the
regulator as capital diminishes. No single dividing line
should trigger action, but there should be a series of
such trigger points where the effect of going through
any one of them is relatively minor, but the cumulative
effect is large. In these graduated responses no
distinction should be made between losses caused by
idiosyncratic or general market developments.
Under a related concept (the “precommitment
approach” to bank supervision) the banks’ own
assessments of their capital needs3 are used as the
basis of supervision. At the beginning of each period,
the bank evaluates its need for capital and the bank is
subsequently required to manage its risks so that its
3 4
As determined by their own internal risk models.
Financial Regulation in South Africa: Chapter 3
capital does not fall below the precommitment level.
Penalties are imposed to the extent that capital falls
below the declared levels. There should also be a
decision as to what market movements are so extreme
as to merit government support to withstand them.
Banks would be required to hold capital to meet shocks
up to this limit in stress tests of proprietary models.
However, even in a precommitment and graduated-
response regime there may be cases where
predetermined rules should be overridden. The problem
is, however, that if this is publicly known, the
credibility of the regulator could be seriously
compromised, bearing in mind that it is to create and
sustain such credibility that the precommitment rule is
established in the first place. Can there be any
guarantee that such an override would not turn
regulation into a totally ad hoc procedure? One solution
is to make the intervention agency publicly accountable
for its actions and decisions not to intervene.
3.4 Incentive contracts and structures
Crises in the financial system frequently occur when
there are weak incentives to act prudently. 4 A
necessary ingredient of a robust and stable financial
system is the creation of appropriate incentives and
disciplining mechanisms for all market participants,
especially for owners, managers and financial
system supervisors.
Laws, regulations and supervisory actions provide
incentives for regulated firms to adjust their actions
and behaviour, and to control their own risks
internally. They can usefully be viewed as “incentive
contracts” within a standard principal-agent
relationship where the principal is the regulator and the
agent is the regulated firm. Within this general
framework, regulation involves a process of creating
incentive-compatible contracts so that regulated firms
have an incentive to behave in a way consistent with
the objectives of systemic stability, institutional safety
and soundness, and consumer protection. Similarly,
there should be incentives for the regulator to set
Financial crises are discussed in Chapter 5.
33
appropriate objectives, to adopt well-designed rules,
not to over-regulate and to act in a timely fashion (for
instance, in the face of pressure for forbearance). If
incentive contracts are well designed they will induce
appropriate behaviour by regulated firms. Conversely,
if they are badly constructed and improperly designed,
they might fail to reduce systemic risk (and other
hazards regulation is designed to avoid) or have
undesirable side-effects on the process of financial
intermediation (e.g. impose high cost). At centre stage
is the issue of whether all parties have the right
incentives to act in a way that satisfies the objectives
of regulation.
The incentive structures and moral hazards faced by
decision makers (owners and managers, lenders,
borrowers and central banks) are the major issues to
consider in the regulatory regime. Some analysts
ascribe many of the recent financial crises to various
moral hazards and perverse incentive structures, such
as fixed exchange-rate regimes and anticipated lender-
of-last-resort actions5.
3.5 Market monitoring and discipline
Monitoring is not only conducted by official agencies
which have this specialist task. In well-developed
financial regimes the market also monitors the
behaviour of financial firms. The discipline imposed
by the market can be as powerful as any sanctions
imposed by official regulatory agencies. However, in
practice, the disciplining role of the markets (including
the inter-bank market which in many jurisdictions is
able to impose powerful discipline through the risk
premium charged on inter-bank loans) was weak in the
crisis countries of Southeast Asia. This was
predominantly because of the lack of disclosure and
transparency of banks and the fact that little reliance
could be placed on the quality of the accountancy data
provided in bank accounts. In many cases, standard
accountancy and auditing procedures were not applied
rigorously. In some cases there was wilful
misrepresentation of the financial position of banks
5
Such as perceived bailouts by the IMF.
34
and non-financial companies. Overall, market
discipline can work effectively only on the basis of full
and accurate disclosure and transparency.
Good quality, timely and relevant information
disclosure should be available to all market
participants and regulators so that asset quality,
creditworthiness and the condition of financial
institutions can be assessed. This disclosure includes
the timely publication of relevant financial data on the
soundness of financial institutions, and the adoption of
comprehensive and well-defined accounting principles
that conform to agreed international standards.
The key issue is who is to undertake the monitoring.
Several parties could potentially monitor the manage-
ment of financial institutions: owners, depositors,
clients, rating agencies, official agencies (e.g. the
central bank or other regulatory body) and other firms
in the market. In general, excessive emphasis has been
given to official agencies. The danger is that a
monopoly monitor is established with all the problems
normally associated with monopoly power. There may
even be an adverse incentive effect in that, given that
regulatory agencies conduct monitoring and
supervision on a delegated basis, the incentive for
others to conduct monitoring may be weakened. The
role of other potential monitors (and notably the
market) needs to be strengthened in many, including
well-developed, financial systems. Among other
considerations, this reduces the monopoly power of a
single, official supervisory agency. This in turn requires
adequate information, as well as disclosure and
transparency in the operations of financial institutions.
There should be greater incentives for other parties to
monitor firms in parallel with official agencies.
Within the general framework of monitoring, a
major dimension is the extent to which the market
undertakes monitoring and imposes discipline on the
risk taking of financial institutions. Given how the
business of the financial sector has evolved and the
nature of the market environment in which firms now
operate, less reliance should be placed on supervision
by official agencies and a greater role should be played
by the market. Market disciplines need to be
Financial Regulation in South Africa: Chapter 3
strengthened. The issue is not so much about market
versus agency discipline, but the mix of all aspects of
monitoring, supervision and discipline.
The Basel Committee on Banking Supervision has
recognised that supervisors have a strong interest in
facilitating effective market discipline as a lever to
strengthen the safety and soundness of the banking
system. It argues that market discipline has the
potential to reinforce capital regulation and other
supervisory efforts to promote safety and soundness in
banks and financial systems.
Moreover, some analysts are sceptical about the
power of official supervisory agencies to identify the
risk characteristics of banks compared with the power
and incentives of markets. They have advocated that
banks should be required to issue a minimum amount
of subordinated and uninsured debt as part of the
capital base. Holders of subordinated debt would
have an incentive to monitor the risk taking of banks.
The market would apply discipline, as the markets’
assessment of risk would be reflected in the risk
premium in the price of the traded debt. In particular,
because of the nature of the debt contract, holders of
a bank’s subordinated debt capital do not share in the
potential upside gain through the bank’s risk taking,
but stand to lose if the bank fails. They therefore have
a particular incentive to monitor the risk profile of the
bank in contrast to shareholders who, under some
circumstances, have an incentive to support a high-
risk profile.
The merit of increasing the role of market discipline
is that large, well-informed creditors (including other
financial institutions) have the resources, expertise,
market knowledge and incentives to conduct
monitoring and to impose market discipline.6
In order to develop market discipline as a regulatory
instrument, the following “directives” should be
emphasised:
6
For instance, it has been argued that the hazardous state of BCCI
was reflected in market prices and inter-bank interest rates long
before the Bank of England closed the bank.
Financial Regulation in South Africa: Chapter 3
Regulation should not impede competition
but should enhance it and, by addressing
information asymmetries, make it more
effective in the market place
However well-intentioned, regulation has the potential
to compromise competition and to condone, if not in
some cases endorse, unwarranted entry barriers,
restrictive practices and other anti-competitive
mechanisms. Historically regulation in finance has
often been anti-competitive in nature. But this is not an
inherent property of regulation. Because there are clear
consumer benefits and efficiency gains to be secured
through competition, regulation should not be
constructed in a way that impairs competition.
Regulation and competition need not be in conflict –
on the contrary, properly constructed they are
complementary. Regulation can, therefore, enhance
competition. It can also make it more effective in the
marketplace by, for instance, requiring the disclosure
of relevant information that can be used by consumers
for making informed choices.
Regulation should reinforce, not replace,
market discipline, and the regulatory regime
should be structured so as to provide greater
incentives than those existing at present for
markets to monitor financial firms
Where possible, market discipline (e.g. through
disclosure) should be strengthened. This means
creating incentives for private markets to reward
good performance and penalise hazardous behaviour.
Regulation and supervision should complement and
support, and never undermine, the operation of
market discipline.
Regulators should, whenever possible, utilise
market data in their supervisory procedures
The evidence indicates that markets can give signals
about the credit standing of financial firms which,
when combined with inside information gained by
supervisory procedures, can increase the efficiency of
the supervisory process. If financial markets are able
to assess a firm’s market value as reflected in the
market price, an asset-pricing model can in principle
be used to infer the risk of insolvency that the market
35
has assigned to each firm. However, there are
limitations to such an approach, hence it would be
hazardous to rely exclusively on it. For instance, it
assumes that the market has sufficient data upon which
to make accurate assessments of firms, and it equally
assumes that the market is able to efficiently assess the
available information and incorporate this into an
efficient pricing of firms’ securities.
There should be a significant role for rating
agencies in the supervisory process
Rating agencies have considerable resources for and
expertise in monitoring financial institutions and
making assessments of risk. It could be made a
requirement, as in Argentina, for all banks to have a
rating which would be made public.
3.5.1 Assessment
Though market discipline is potentially very powerful,
it has its limitations. This means that, in practice, it is
unlikely to be an effective alternative to the role of
official regulatory and supervisory agencies:
• Markets are concerned with the private cost of
financial institution failure and reflect the risk of
this in market prices. The social cost of bank
failures, by contrast, may exceed the private cost
and therefore the total cost of, say, a bank failure
may not be fully reflected in market prices.
• Market disciplines are not effective at monitoring
and disciplining public-sector financial institutions.
• In many countries, there are limits imposed on the
extent to which the market in corporate control (the
takeover market) is allowed to operate. In
particular, there are frequently limits, if not bars,
on the extent to which foreign institutions are able
to take control of banks and other financial
institutions, even though they may offer a solution
to undercapitalised institutions.
• The market is able to efficiently price financial
institutions securities and inter-bank loans only to
the extent that relevant information is available.
Disclosure requirements are, therefore, an integral
part of the market-disciplining process.
• It is not self-evident that market participants
36
always have the necessary expertise to make risk
assessments of complex, and sometimes opaque,
financial institutions.
• In some countries, the market in debt of all kinds
(including securities and debt issued by banks) is
limited, inefficient and cartelised.
• When debt issues are very small it is not always
economically feasible for a rating agency to
conduct a full credit rating of firms.
Though there are clear limitations on the role of
market discipline, the global trend is appropriately
leaning towards placing more emphasis on market data
in the supervisory process. The contention is not that
market monitoring and discipline can effectively
replace official supervision, but that these have a
potentially powerful role which should be strengthened
within the overall regulatory regime. In addition it has
been argued that broadening the number of those who
are directly concerned about the safety and soundness
of financial institutions reduces the extent to which
insider political pressure can be brought to bear on
financial regulation and supervision.
3.6 Corporate governance
Ultimately, all aspects of the management of a financial
institution are corporate governance issues. This means
that if firms behave hazardously this is, to some extent,
a symptom of weak internal corporate governance. This
may include, for instance, a hazardous corporate
structure for the firm, lack of internal control systems,
weak surveillance by (especially non-executive)
directors, and ineffective internal audit arrangements.
Corporate governance arrangements were evidently
weak and under-developed in banks in many of the
countries in distress.
Some ownership structures of financial institutions
in the private sector can produce poor corporate
governance. In some cases, particular corporate
structures (e.g. banks being part of larger
conglomerates) encourage connected lending and a
weak risk analysis of borrowers. This has been found
to be the case in a significant number of bank failures
in the countries of Southeast Asia and Latin America.
Financial Regulation in South Africa: Chapter 3
Some corporate structures also make it comparatively
easy for banks to effectively conceal their losses and
an unsound financial position.
A key issue in the management of financial
institutions is the extent to which corporate
governance arrangements are suitable and efficient for
the management and control of risks. Corporate
governance arrangements include issues of corporate
structure, the power of shareholders to exercise the
right to demand the accountability of managers, the
transparency of corporate structures, disclosure of the
authority and power of directors, internal audit
arrangements and lines of accountability of managers.
In the end, shareholders are the ultimate risk takers and
agency problems may induce managers to take more
risks with the firm than the owners would wish. This
in turn raises issues about what information
shareholders have about the actions of the managers to
which they delegate decision-making powers, the
extent to which shareholders are represented on the
board of directors of the firm and the extent to which
shareholders have power to discipline managers.
In essence, corporate governance arrangements
should provide for the effective monitoring and
supervision of the risk-taking profile of financial
institutions. These arrangements would provide for,
inter alia,
• a management structure with clear lines of
accountability;
• independent non-executive directors on the board;
• an independent audit committee;
• the four-eyes principle for important decisions
involving the risk profile of the firm;
• transparent ownership structures;
• internal structures that enable the risk profile of the
firm to be clear, transparent and managed; and
• the monitoring of risk analysis and management
systems.
Financial Regulation in South Africa: Chapter 3
3.7 Discipline on and accountability of
the regulators
Whether they like it or not, regulators should be
publicly accountable through credible mechanisms.
Regulatory agencies have considerable power over
regulated firms and the consumer through their
influence on the terms on which business is conducted.
For this reason, agencies need to be accountable and
their activities transparent. In addition, public
accountability can also be a protection against political
interference in the decisions of the regulatory agency.
Moreover, it creates incentives against forbearance.
However, difficulties arise with transparency when, for
example, it may be prudent for a central bank’s
successful action in averting a bank failure or systemic
crisis to keep specific information undisclosed. One
possible approach is to create an audit agency of the
regulator with the regulator being required to report on
a regular basis to an independent person, or body. The
report would cover the objectives of the regulator and
the measures of success and failure. The audit
authority would have a degree of standing that would
force the regulatory agency to respond to any concerns
raised. In due course, the reports of the regulator to the
agency would be published.
4. Instruments of regulation
The regulatory agency needs to utilise the full range
of regulatory instruments at its disposal in the
implementation of a regulatory regime. The
alignment of the regulatory instruments with the
regulatory objectives and intermediate goals is
discussed in the regulatory strategic framework
developed in Chapter 4.
The main instruments in the components of the
regulatory regime are listed in Tables 3.1 to 3.7.
37
 Table 3.1: Instruments of rules and regulation
1. Entry and standards constraints
• accounting standards
• audit standards
• payment and settlement standards
• issuance standards for financial instruments
• fit and proper standards for individuals and firms
• disclosure and advice standards
• corporate governance standards
• inspection and supervision standards for financial institutions
• cross-border information-sharing standards
• financial conglomerate supervision standards
• financial crime and money-laundering standards
2. Ownership constraints
• cross-holdings
• foreign holdings

3. Functional activity constraints

• demarcation requirements
4. Jurisdictional constraints
• domestic versus international
• between regions
5. Pricing constraints
• fixed prices
• price ceilings
6. Operational constraints
• prudential requirements
• market business conduct requirements
• trading requirements
• competence requirements
• compensation schemes requirements
• complaints procedures requirements

Table 3.2: Instruments of official monitoring and supervision

• official reporting requirements
• periodic spot inspections
• permanent positioning of inspection staff
• regular interviews with non-executive directors

38 Financial Regulation in South Africa: Chapter 3

 Table 3.3: Instruments of intervention and sanctions
• Structured Early Intervention and Resolution regime
• timely assessment of risk and insolvencies
• timely closure of undercapitalised institutions
• detection of price manipulation and unfair trading practices

Table 3.4: Instruments of incentive contracts and structures

1. Incentives for appropriate code of business conduct
• corporate governance
• compliance arrangements
• conflict of interest avoidance incentives
• gridlock avoidance incentives
2. Incentives to encourage prudential risk exposures
• incentives to contain systemic risks
• internal risk assessment arrangements and capital adequacy (loan concentration, interconnected lending,
cross-market risk assessment, fostering official oversight)
• incentives to contain credit risk (timely and adequate provisions against doubtful and bad debt, correct
pricing of risks, correct loan and asset valuation)
• incentives to contain market risk (value-at-risk assessment procedures)
• incentives to contain operational risk (audit arrangements, forensic investigation, management control
systems)
• incentives to contain liquidity risk (stress testing of cash-flow models))
• incentives to encourage effectiveness and efficiency (incentives for regulatory cost-benefit analysis,
incentives for training and consumer education, incentives for fostering competition, incentives to ensure
that owners and managers lose through their failure)

Table 3.5: Instruments of market monitoring and discipline

• international accounting standards
• disclosure and transparency arrangements
• less restrictive and anti-competitive mechanisms
• role of external auditors
• ratings by private credit-rating agencies
• assessments by the capital market
• consumer and investor education
• fewer entry barriers
• remote trading by international traders

Financial Regulation in South Africa: Chapter 3 39

 Table 3.6: Instruments of corporate governance
• leadership, enterprise, integrity and judgement
• appointment of board directors (executive and non-executive)
• strategy and values to achieve wealth creation and protect reputation
• company performance and business plans
• compliance with relevant laws
• communication with stakeholders
• accountability to shareholders
• relationship with stakeholders
• balance of power and separating roles of CEO and chairman
• internal procedures to ensure control
• performance assessment of board
• management appointments and development
• technology and competitiveness
• risk management
• annual review of future solvency

Table 3.7: Instruments of discipline on and accountability of regulators

• public accountability of the regulator (including cost of regulation)
• precommitment against public forbearance
• regulatory co-ordination and harmonisation between domestic and foreign regulatory agencies
• regulatory audit agency

40 Financial Regulation in South Africa: Chapter 3

 Chapter 4

AN INTEGRATED TARGET-INSTRUMENT APPROACH TO

FINANCIAL REGULATION
1. Introduction
When considering regulatory strategy, an analytical
framework has to be established at the outset. This
framework should elucidate how the objectives and the
instruments available in the regulatory regime can be
aligned and potential conflicts between them
eliminated. When constructing such a framework, four
criteria need to be met. It should be –
• coherent to those who need to use it – i.e. easily
understood;
• robust – based on sound economic and
methodological analysis;
• consistent over time – valued and relevant for
different strategy exercises; and
• manageable – operational and based on measurable
concepts.
A problem arises if some of the high-level objectives
are too broad, unmeasurable and unmanageable. In
such a case it is necessary to define intermediate goals
and targets that are more operational and manageable.
These targets are reasonably closely related to an
objective, although they are not objectives in
themselves (i.e. not necessarily desired in their own
right). Achieving the targets is therefore a reasonable
proxy for an objective.
The framework for a regulatory strategy that
emerges is summarised in Diagram 4.1. It begins with
a statement of objectives, i.e. what the authorities are
attempting to achieve through regulatory strategy. This
sets the high-level regulatory objectives, and has
components within it that should be identified
separately. The objectives are in turn decomposed into
intermediate goals and operational targets. The
components of the regulatory regime are in turn
broken down into regulatory instruments. These
instruments are at the disposal of the authorities and
can contribute directly to achieving the targets.
When implementing a regulatory strategy using
such a framework, the authorities usually rely on two

Diagram 4.1: The strategy framework

Objectives
(the ultimate “high-level” objectives the authorities are
attempting to achieve through the regulatory strategy)

Goals and operational targets

(specific and measurable regulatory targets that
contribute to the ultimate regulatory objectives)

Regulatory regime and supporting instruments

(what the authorities have at their command,
such as rules and contracts)

Financial Regulation in South Africa: Chapter 4 41

conflict-conciliatory principles, namely that an
integrated approach should be followed with regard
to regulation, and that this approach should be
supported by target-instrument procedures. This
chapter sketches the use of these conflict-conciliatory
principles in practice.
2. The overall regulatory strategy
matrix
The analysis to follow is based on the “regulatory
regime” and the seven key components discussed in
Chapter 3:
• Rules imposed by regulatory agencies;
• monitoring and supervision by official agencies;
• intervention and sanctions by official agencies;
• incentive structures;
• market monitoring and discipline;
• corporate governance arrangements in financial
firms; and
• the accountability of regulatory agencies.
Table 4.1 combines in one conceptual framework – a
“regulatory” matrix – the ultimate objectives and
intermediate goals of regulation (as discussed in
Chapter 2) and the policy instruments of regulatory
regime (as sketched in Chapter 3). Placed at the top of
the matrix are the three ultimate objectives of
regulation (systemic stability; safety and soundness of
financial institutions; consumer protection) as well as
their subcomponents (i.e. the intermediate regulatory
goals). On the vertical axis is shown the full regulatory
regime, i.e. the seven major components or classes of
financial instruments. Because of space limitations the
regulatory instruments are not listed in full in the
matrix – see Chapter 2, Tables 2.1 to 2.3.
The intermediate goals are, in effect, a
transformation of the regulatory principles outlined in
Chapter 1. These intermediate goal variables relate on
the one hand directly to the ultimate objectives (see
Chapter 2) and on the other to the regulatory regime
and its instruments (see Chapter 3). Accordingly, the
regulatory instruments are employed with a view to
realising the ultimate objectives. The underlying
premise of this approach is that if the regulatory
42
authorities are successful in achieving their targets they
will, by implication, also realise the intermediate goals
and ultimate objectives. As already noted, the rationale
of this paradigm is that the relationship between the
ultimate objectives is too indirect and diffused.
3. The regulatory regime and
intermediate goals
All the instruments of financial regulation are
ultimately aligned to a specific regulatory target and
goal. In terms of Table 4.1, an X means that the
specific instruments within a component of the
regulatory regime are aligned to the intermediate target
and thus support the particular ultimate objective of
regulation. Although a specific regulatory instrument
may support a specific target, it may also have
negative side-effects. For instance, some policy
instruments that support market efficiency may do so
at the cost of consumer protection or may threaten to
destabilise the financial system.
As is evident from Table 4.1, a number of policy
instruments can usually be aligned to a specific
intermediate regulatory goal and target. An integrated
target-instrument approach to financial regulation
means that both the advantages and disadvantages of
every regulatory instrument have to be taken into
consideration before being employed. Therefore the Xs
in table 4.1 do not indicate that a specific instrument
will always be the appropriate one to address a specific
target(s), but rather that it can be aligned (however
defectively) to a specific target(s). For example,
although official sanctioning of price cartels may
reduce systemic risk, the disadvantages of such a
policy are likely to outweigh the perceived advantages.
In terms of Table 4.1 there are many other instruments
aligned to reduce systemic risks and accordingly in
terms of an integrated target-instrument approach these
other instruments, rather than price fixing, should be
used to reduce systemic risk.
In essence, the target-instrument approach
establishes that, when each instrument affects each
target all targets can be achieved simultaneously only
if there are as many instruments as targets: i.e. there is
Financial Regulation in South Africa: Chapter 4
 Table 4.1: Regulatory matrix: Alignment of regulatory instruments to regulatory goals and objectives
Institutional safety and
Regulatory ultimate objectives Systemic stability Consumer protection
soundness

Regulatory
intermediate goals

liquidity
fairness
schemes

neutrality
disclosure

Proper risk
retail funds

assessment
Competitive
Integrity and
Competence
Protection of

infrastructure
infrastructure
Fit and proper
Access to retail

competitiveness
competitiveness

Financial Regulation in South Africa: Chapter 4

Sufficient market
financial services

market exposures
Acceptable cross-
Transparency and

directors and staff

Global institutional

Proper institutional

Competitive market
Retail compensation

currency mismatches
Securities markets as
Regulatory regime and

efficiency and economy

Acceptable maturity and

Regulatory effectiveness,
Adequate product/service

its instruments

alternative to intermediation
1. Official rules and regulations
1.1 Entry and standards constraints X X X X X X X X X X X X X

1.2 Ownership constraints X

1.3 Functional activity constraints X X X

1.4 Jurisdictional constraints X X X

1.5 Pricing constraints X

1.6 Operational constraints X X X X X X X X X X X X

2 Official monitoring and supervision X X X X X X X X X X

3. Intervention and sanctions X X X X X X X

4. Incentive contracts and structures X X X X X X X X X X

5. Market monitoring and discipline X X X X X X X X X X X X X X X X

6. Corporate governance X X X X X X X X X

7. Discipline/accountability of
X X X
regulators

43
some optimal combination of instruments that
achieves the desired combination of targets. The value
(or intensity) of each instrument is aimed not only at
having positive effects on particular targets, but may
also be used to neutralise the negative effects of other
instruments. This analysis indicates therefore that, if
each of the regulatory objectives is to be secured, a
multi-instrument approach is required: i.e. an
optimising approach designed to achieve satisfactory
levels of competition, efficiency and safety. No single
instrument will suffice, and the more one objective is
sought through a particular instrument, the greater will
be the demand on other instruments to offset the
potentially negative effects upon other regulatory
objectives. Therefore a co-ordination of the various
objectives and instruments is required. An example
can be found in arrangements made for the protection
of the consumer. One way of dealing with potential
conflicts of interest that may work against the interest
of the consumer is regulation that restricts a financial
firm’s range of allowable business. If such regulation
is eased, it may be necessary to resort to other
measures to limit the potential for conflicts of interest,
such as recourse to dedicated capital, Chinese walls,
rules of business conduct, compliance officers and
disclosure rules.
As regulatory instruments generally constrain the
activities of market participants (and thus may harm
innovation and efficiency), the ideal should be to use
the minimum number of instruments to obtain the
maximum effect on the intermediate goals. Regulatory
constraints are justified in that they aim to reduce
market failure: i.e. asymmetric information (resulting
in, for instance, insider trading), monopoly powers
(often a result of high entry and/or exit barriers), and
externalities (e.g. systemic risks1). Although the
response of the regulators to market failure may be
successful in extracting more information from the
market (e.g. by way of transparency arrangements,
establishing formalised markets, imposing adequate
disclosures or conduct of business rules), in curtailing
monopoly powers (e.g. by setting rules and outlawing
restrictive trade practices) or in promoting systemic
44
stability (e.g. by harmonising regulation and by
introducing capital-adequacy rules or solvency
regimes), it may nonetheless fail on one or more of the
following grounds:
• Technological improvements and financial
innovation may result in recourse to increasingly
more regulations to address a specific problem
(what might be termed “regulatory escalation”).
What may start as a small issue, over time, may
becomes a highly costly exercise which becomes
totally out of proportion to the initial problem.
• Regulation may create monopoly problems in its
own right (e.g. the imposition of new and/or more
stringent entry requirements).
• Regulation may create a moral hazard (e.g. bank
deposit insurance).
• Regulation may result in inefficiencies, particularly
when the restrictions are not related to risk. For
instance, capital requirements that are not
accurately based upon actuarial risks may impact
adversely on an institution’s efficiency.
• Regulation may deteriorate into over-regulation,
which will reduce consumers’ access to cheaper
products owing to the cost of excessive regulation.
• Regulation may result in welfare losses as a
consequence of rent-seeking efforts. Accordingly,
interest groups may be induced to lobby strongly to
maintain their economic rents.
• Regulatory capture may occur whereby certain
parties come to exploit opportunities to manipulate
1
Although in the short-run systemic stability can often be
enhanced by more stringent controls, in the medium to long term
such controls may endanger the stability of the financial system.
From an analytical point of view a clear distinction should be
drawn between the stability of the financial system and that of an
individual company. In competitive markets, firms in crisis may
be a symptom of “creative destruction”, as the emergence of new
undertakings logically requires the demise of others which may
have become obsolete. The emergence of new products, new
firms and even whole new industries goes hand-in-hand with the
disappearance of outdated products, the often brutal elimination
of whole areas of activity and also, naturally, of individual firms.
The disappearance of some production units in such a manner
may lead to a higher level of efficiency and overall systemic
stability, as the remaining firms adjust to a new efficiency
standard and the new dynamic market conditions. Ultimately
there is a natural conflict between creativity and a peaceful life.
Financial Regulation in South Africa: Chapter 4
 the deployment of regulations to their advantage,
which in turn results in the authorities serving the
interests of the suppliers rather than consumers.
• Regulation may have undesirable side-effects. For
instance, transparency arrangements are usually
introduced at the cost of liquidity arrangements
(e.g. order- versus quote-driven market structures).
Because the statutory constraints placed on the
financial system can so easily backfire if not properly
co-ordinated in an overall target-instrument approach,
the regulatory authorities in most industrial countries
have started to place greater emphasis on market
discipline. This process entails a complex
realignment of official rules and regulation in favour
of market forces and discipline (as will be discussed
in Section 4 below).
The seven components of the regulatory regime, as
listed in the section on the left axis of Table 4.1 and
their alignment with the intermediate goals shown at
the top of the table, will now be discussed.
3.1 Rules and regulations
Ultimately, statutory rules and regulations aim at
constraining private-sector activities. Usually these
regulatory instruments are grouped under six broad
headings, namely: entry and standards constraints;
ownership constraints; functional activity constraints;
jurisdictional constraints; pricing constraints; and
operational constraints. As the subject is vast, each of
these topics will be presented in a summarised format.
The objective is to illustrate the methodological
Table 4.2: Impact of regulating financial individuals and instruments by
minimum standards requirements
Favourable
• Encourages the employment of fit and proper
individuals, which reduces systemic risks
• Encourages ethical standards being maintained
• Supports market liquidity, as trades are executed by
suitable persons
• Can be a cost-effective, flexible and practitioner-
based way of regulation
• Enhances public confidence
Financial Regulation in South Africa: Chapter 4
approach adopted in this report, rather than to present a
detailed analysis of each component.
3.1.1 Entry and standards constraints
Entry and standards requirements are many and varied
and often depend on a specific sector in the financial
industry. By contrast, standards of probity, such as
having a clean criminal record, are applicable generally.
In a nutshell, the entry and standards requirements
involve (i) stipulating “fit and proper” standards for
individuals and for firms, (ii) the setting of disclosure
and advice standards, which are particularly important
in the retail market, and (iii) the setting of minimum
issuance requirements for financial instruments. Each
of these components will be briefly discussed below.
Fit and proper standards for individuals
This constraint relates to the authorisation of
individuals and firms engaging in financial services.
For the greater part, regulation has a bearing on the
firm rather than the individual. Indeed, even the sole
trader can be viewed legally as a one-man firm.
Nonetheless, a few regulatory instruments are directly
applicable to the individual. Of importance here are
the restrictions on every financial instrument trader or
principal to be “fit and proper” (meaning honest,
competent and solvent).
The main disadvantage of stipulating fit and proper
standards for individuals is that they can be employed
as a barrier to would-be competitors. Therefore, entry
examinations should aim at weeding out only totally
unsuitable persons. Moreover, examinations may also
Unfavourable
• Imposes an entry barrier to trade
• May result in a de facto restriction
• May give false security to consumers, as the usually
minimum level of competence is examined only
once and not on a continuous basis
45
give a false sense of security to the extent that
competence may be measured only once and may not
be a continuous process (as is the case with, for
instance, aircraft pilots). This raises the issue of whether
there should be a continuous authorisation procedure.
Minimum entry standards for firms
Before a financial institution can be established, the
authorities stipulate various entry and minimum
standards requirements. In addition to its employees
who have to be fit and proper, a firm has to maintain a
minimum capital base at all times, and the firm’s
major shareholders, its senior management and its
infrastructural systems have to be satisfactory. These
restrictions are primarily intended to improve systemic
stability and to protect small investors (by ensuring
that only firms of a minimum quality do business). In
effect, these restrictions are designed to alleviate a
form of market failure, namely the inability of
consumers to make a proper judgement about the
integrity and competence of firms (i.e. the problem of
asymmetric information).
In the absence of minimum standards imposed by
regulatory agencies, average standards in the industry
may decline due to moral hazard and adverse selection.
In the former case firms are induced to behave badly
because they perceive competitors making short-term
gains (e.g. higher sales) because they have low
standards of competence and integrity which are not
transparent to ill-informed consumers. Equally, there
may be adverse selection because good firms are
driven out by the bad. A role of regulation, therefore, is
to set minimum standards that all firms know will also
be imposed universally on their competitors.
Table 4.3: Impact of entry requirements for firms
Favourable
• Enforces minimum standards and so reduces
systemic risk
• Assists investors who are unable to judge the
integrity and competence of firms
• Enhances shareholders’ control over a firm’s managers
• Can be a cost-effective, flexible and practitioner-
based way of regulation
46
Disclosure and advice standards
requirements
The regulatory authorities aim at improving market
transparency without sacrificing overall financial
stability and efficiency. Disclosure requirements relate
both to the terms of contracts and the overall financial
position of a supplier of financial services. To protect
small investors and to reduce the problem of
asymmetric information, the authorities stipulate
appropriate disclosure and minimum standards of
advice (e.g. for life assurance products). Often a
financial contract goes wrong because the small
investor receives bad advice and is uninformed about
some crucial details at the time the contract is bought
so that it differs from his expectations2. It is also
reasonable to allow the consumer of what are often
complex financial contracts, a period of time after a
contract has been signed to seek independent advice
before the contract is finally enforced (i.e. a statutory
“cooling-off” period to reconsider the contract).
Unless there is appropriate disclosure3, the burden of
responsibility shifts inevitably towards prudential
supervision and the regulatory authorities. For instance,
on a cost-benefit analysis basis it seems better to
2
In South Africa nearly one-third of all life assurance policies
taken out lapse during the first few years, although this is not
only because the product was inappropriate or miss-sold. There
are many other reasons (e.g. a change in customer’s
circumstances) why a policy may lapse.
3
For instance, unless banks are required to make provisions against
doubtful loans on a timely basis, there is a risk that losses will be
understated and remain undetected. This can obscure the build-up of
distress. In addition, external auditors play in an important role in a
disclosure regime if they are required to report criminal evidence to
the relevant authority (see e.g. the Bingham Report on BCCI).
Unfavourable
• Raises entry barriers
• May result in a de facto trade restriction
Financial Regulation in South Africa: Chapter 4
address the potential moral hazard between tied
insurance agents versus independent insurance advisers
by full disclosure and a “client’s guide”, rather than to
enforce a trade restriction (e.g. polarisation) that may
so easily harm business efficiency. In the final analysis,
regulation should never be regarded as an alternative to
information disclosure.
With respect to the overall position of a financial
institution, the increasing opaqueness of the
financial system has made appropriate disclosure to
enhance transparency even more important than in
the past. Today there is not only a blurring of the
distinctions between different forms of financial
intermediation, but also a proliferation of financial
instruments, derivatives and other off-balance-sheet
operations. As a result it is far more difficult to
evaluate the direct risks run by a financial
intermediary, and these trends also create hitherto
unknown linkages (the indirect risks) between
different parts of the financial industry.
Though disclosure may be useful in preventing the
build-up of distress, once latent distress is present,
Table 4.4: Impact of disclosure and advice standards requirements
Favourable
• Reduces the problem of asymmetric information for
the small investor. Without transparency, investors
cannot carry out proper risk assessments
• Acknowledges the right of the retail investor to know
whether the intermediary or the client is at risk in
respect of an investment and whether the
intermediary is acting as a principal or an agent
• The more information supplied to the client, the
lesser the need for regulation
• The longer the duration of a contract, the greater the
disclosure required
• Any potential moral hazard (e.g. between tied versus
untied insurance agents) has to be primarily
addressed by detailed disclosure requirements
• Long-term contracts, such as life assurance, are not
subject to “repeat order” possibilities and therefore
the seller is inclined to view the sale as a once-off
transaction. Accordingly more disclosure is required
for these contracts
Financial Regulation in South Africa: Chapter 4
simply revealing the underlying risk conditions may
precipitate a disorderly market reaction.
Accompanying stabilising measures are therefore
necessary (e.g. appropriate funding capital, industry-
financed deposit insurance or guarantee schemes) as
well as mutually reinforcing policies at the
macroeconomic and microeconomic level with a view
to ensuring financial discipline (particularly a strong
long-term anti-inflation commitment inter alia to
temper the fluctuations in financial asset prices).
A key issue, and area of dispute, in disclosure is
whether disclosure of relevant information for the
consumer should be mandatory (and required by the
regulator) or whether reliance can be put on financial
firms voluntarily disclosure of relevant information.
Some American academics, for instance, have argued
against mandatory disclosure and that it may be
against the consumer interest. It is argued that
regulatory agencies are not able to specify
universally useful disclosure rules and “may design
rules that keep financial product providers from
communicating effectively with consumers”. He
Unfavourable
• May adversely influence the competitive neutrality
between tied and untied insurance agents
• Transparency arrangements are usually achieved at
the cost of liquidity arrangements (e.g. order- versus
quote-driven market structures)
• False sense of security created
• Wrong information may be mandatorily disclosed
• Regulators do not know what information consumer
needs
• “Minimum” standards become “normal” standards
47
suggests that, on balance, mandatory disclosure is
more harmful than beneficial.
There are three main arguments in favour of
mandatory disclosure requirements:
• Comparison between alternative products is eased,
and hence consumers’ transactions costs are
lowered, if disclosure is made on the same basis by
all firms;
• standardised information can help consumers make
choices: in this sense, mandatory disclosure has a
positive externality;
• the consumer is often uncertain about what is
relevant information to demand when complex
products are involved.
It is difficult to see how mandatory disclosure would
be harmful to consumers unless in some way it
prevented or inhibited firms from disclosing more than
the stipulated minimum which they would have done
in the absence of a mandatory requirement.
Conceivably, it could create the impression in some
consumers’ minds that, because it is mandated, this is
all they need to know in order to make a decision
about a product or contract.
It is true that regulators do not know what
Table 4.5: Impact of regulating financial instruments by minimum standard requirements
Favourable
• Reduces systemic risk by setting minimum quality
standards for instruments
• Creates uniformity among classes of instruments
and thus promotes competitive neutrality among
issuers
• Enhances the supply of information to investors by
stipulating specific disclosure requirements (e.g.
debenture prospectus)
• Enhances investors’ protection if an exchange
supervises issuing and trading (for listed instruments
only)
• May enhance market liquidity if all instruments are
traded on exchanges
• Can be a cost-effective, flexible and practitioner-
based way of regulation
• Enhances consumer confidence
48
information consumers require as, in some cases, what
is relevant is specific to the individual. All that
mandatory disclosure does is set out minimum
disclosure requirements on a consistent and
standardised basis that all firms must adhere to for all
retail customers. This does not preclude additional
information being given. Indeed, if (as is contended by
critics of mandatory disclosure) there is an incentive
for firms to supply information, this will remain over
and above any minima established by regulation.
Minimum issue standards for financial
instruments
If required, the regulation of financial instruments can
be increased in steps. At its lowest level the authorities
can stipulate minimum issue requirements (e.g. in
respect of quality, tenor, denomination or
accompanying disclosure requirements). Next they can
prescribe the trading procedures for specific
instruments4. Lastly, the authorities can stipulate, by
way of a licensing system, that recognised investment
exchanges will supervise the issue of (and trade in)
specific instruments, which implies that the financial
4
For example, foreign currency may only be traded by banks in
South Africa.
Unfavourable
• May reduce market liquidity if regulatory restrictions
become too expensive
• Reduces consumer choice by eliminating poor, but
also cheap, financial instruments
• Reduces the supply of high risk/high return
instruments for portfolio diversification
• May result in the playing field not being level between
the issuers of listed and unlisted instruments
• May be avoided by financial engineering
• “Minimum” standards become “normal” standards
Financial Regulation in South Africa: Chapter 4
instrument is listed (e.g. futures contracts). The listing
of instruments on an exchange should preferably be
done at the market’s initiative and not be enforced by
the authorities. As position exposures can usually be
netted for capital adequacy purposes on an exchange
only, listing financial instruments may be attractive to
market participants.
As market efficiency often requires the deregulation
of markets, the importance of regulating financial
instruments and market participants has risen sharply
since the 1980s.5
3.1.2 Ownership constraints
When considering the ownership structure of financial
institutions the issue of whether a financial institution
should be allowed to operate as a multi-functional
financial conglomerate is a thorny one. At stake is
whether, for instance, an insurer may have a majority
stake in a bank or vice versa, or whether a foreign-
owned bank may have a controlling shareholding in a
5
The target-instrument approach often requires greater freedom in
one market and more regulation in another. For instance, to
increase market liquidity and efficiency, dual capacity may be
required, the resulting conflict of interest then being addressed by
rules (e.g. Chinese walls).
Table 4.6: Impact of regulatory restrictions on financial conglomerates
Favourable
• Reduces the concentration of power in the financial
system
• Reduces the business risk emanating from running a
multi-faceted business enterprise
• Reduces systemic risk, as the larger is the
conglomerate, the higher are the costs to society if it
fails
• Simplifies bank-deposit insurance and the lifeboat
facility of the central bank because the range of
functions of a firm is limited
• May reduce potential moral hazard within a firm. It
thus reduces the cost of policing complex
boundaries such as Chinese walls
• Makes it easier to match functional and institutional
regulation
• Avoids contamination
Financial Regulation in South Africa: Chapter 4
local commercial bank6, or whether a pyramid holding
company7 may be listed on the stock exchange. A
major question today is whether banks, in particular,
(but also other financial institutions) can be owned by
non-financial companies. Regulatory restrictions in
this respect are aimed at reducing the concentration of
economic power (and thus enhancing competition) and
systemic risk.
As is evident from Table 4.6, some major
disadvantages arise from constraining financial
conglomerates. To some extent these restrictions could
be replaced by appropriate capital standards and by
encouraging international competition. However, it is
mainly the underlying philosophy of society that
determines whether financial conglomerates are to be
allowed. If they are allowed, it is desirable that adequate
6
A commercial bank can be considered to be a “High Street” bank
if it has a large retail customer base and is a major participant in
the inter-bank payment and settlement system.
7
A pyramid holding company is a substitute device for the issue of
non-voting (or low-voting) shares so that a minority shareholder
may be able to retain or establish absolute voting control without
a majority of the underlying shares. Obviously, no investor is
forced to take up such non-voting shares in a company, but often
they are keen to do so nonetheless if the investment seems to be
capable of ensuring above-average returns.
Unfavourable
• Reduces competition as it restricts free entry into the
industry
• Increases a firm’s business risk by reducing its
ability to diversify its risks in other businesses
• Reduces a firm’s benefits of economies of scale and
scope
• Obstructs the elimination of possible excess
production capacity in specific activities (particularly
in banking)
• Limits the response to outside firms encroaching on
the traditional business of a firm. The issue of
growing competition between financial and non-
financial institutions is of particular importance here
• Limits the flexibility of a firm’s response to shocks to
“existing” business areas
49
and full (consolidated) accounting information is
available for such financial conglomerates.
Restrictions on foreign shareholding in a local
commercial bank are normally dictated by national
strategic considerations, such as the payments
mechanism being controlled by local institutions.
Today, this view is increasingly being challenged
owing to the impact of globalisation.
Pyramid companies are no longer allowed in most
industrial countries because the conflicts of interest
between the classes of shareholders are considered too
great (see Table 4.7).
3.1.3 Functional activity constraints
As with regulation related to financial conglomerates,
regulation with respect to the range of allowable
business that can be undertaken by financial
institutions has major implications for the structure of
the financial system. At stake is the structural
spectrum, which is the extent to which institutions are
forced to concentrate on a narrow range of business8,
or whether they are allowed to conduct a wide range of
financial services. This amounts to whether the
structure of the financial system is based upon
differential and specialised financial institutions
8
For example, the Glass Steagal Act in the US has historically
sought to keep commercial and investment banking separate.
Table 4.7: Impact of regulatory restrictions on pyramid holding companies
Favourable
• Curtails serious concentrations of economic power
• Curtails corporate dynasties with absolute control
and possible succession problems in future
• Allows hostile takeovers (which would be impossible
if a single shareholder has absolute control)
• Politically attractive, as “shareholder democracy”
often demands “one share, one vote”
50
providing specialised services or upon institutions
providing a wide range of services. In particular, the
issue arises as to whether banking, insurance
underwriting, securities trading and fund management
may be conducted within the same firm and, if so, to
what extent Chinese walls, fire walls and dedicated
capital allocated to each activity are to be imposed.
By restricting the functional activity of every
financial institution to the four main activities of a
financial system (banking, securities trading, fund
management and insurance) the authorities try to
ensure that there is a clearly defined relationship
between institutions and functions9. To some extent
regulation is simplified, as there is a precise and
exclusive parallel between institution and function – if
banking is to be regulated then this is focused on those
unique institutions called “banks”, while the regulation
of insurance focuses on insurance companies.
Even if the authorities allow multi-functional
financial conglomerates they may still stipulate that
different functional activities shall be handled in
separately capitalised subsidiaries. The premise
underlying this restriction is the promotion of systemic
stability (for instance, financial problems in the
9
The concept of financial intermediation itself has become
somewhat blurred with the huge growth in financial transactions
carried out more or less directly between non-financial enterprises.
Unfavourable
• Restricts proven entrepreneurs from expanding their
companies, without losing control, to the possible
disadvantage of aggregate economic welfare
• Control of the firm remains in the hands of a “long-
term” player, rather than with “punter” shareholders
• Need for “outside” directors to monitor and curb the
power of “inside” management, as there is no longer
a close link between the proprietor shareholder and
management
• Proprietor shareholders no longer have to preserve
their reputation among investors. Accordingly,
operating companies under their control may no
longer be saved from possible bankruptcy
Financial Regulation in South Africa: Chapter 4
banking subsidiary should not contaminate the
insurance subsidiary and vice versa). Unfortunately, in
times of financial distress, these fire wall barriers have
not proven to be particularly effective and credible,
and accordingly some form of consolidated
supervision is called for.
Moreover, functional-activity restrictions are
imposed not only on institutions, but at times also on
markets. Exchanges can either be organised in terms of
one of the four basic instruments (commodities,
currencies, equities and debt)10, or specialise
exclusively in spot market transactions (mostly the
existing commodities and stock exchanges) or only in
derivatives (e.g. the futures and options exchanges).
In principle, regulation should allow for competing
instruments and institutions and therefore competing
financial markets in order to improve market
efficiency. Consequently, the authorities should not
shelter institutions from the impact of competition, as
this may lead to a deterioration in efficiency and may
even create undesirable regulatory gaps. Eventually,
financial firms and exchanges that operate as
monopolies will be bypassed by the impact of
information and trading technology. In such a case
clients’ needs will be served with different instruments
from different markets or countries11. Financial
engineering also has an institutional dimension, as
“regulatory arbitrage” (a tendency for business to shift
to less onerously regulated financial centres) may
cause firms or exchanges to relocate their operations
purely because of regulatory and tax considerations.
The basic issues in the demarcation and
diversification of financial services activities can be
summarised as follows:
• Extent of allowable diversification: At stake here
is the extent to which regulation allows financial
institutions to diversify and thus stipulates the
10
And thus dealing in both the underlying instruments and their
derivatives.
11
According to the old adage: “where there is a will, there is a
loophole”. For instance, although swap contracts are in essence
futures contracts, they are nonetheless traded in informal
markets rather than on a regulated exchange (as is compulsory
for futures contracts).
Financial Regulation in South Africa: Chapter 4
range of business activities allowed. In particular,
regulation may limit the extent to which the same
firm can mix commercial banking, securities
trading and/or broking, and insurance.
• Own service versus agency diversification: A
financial institution may diversify (in the sense of
providing a range of services to clients) either in an
“own service” or “agency” manner. In the former
(either by acquisition or organic growth) the
institution itself provides the service: i.e. the
service is provided in its own name and it is on the
institution’s own balance sheet and therefore it
absorbs the risk and needs appropriate capital
backing. For instance, a bank can provide its own
insurance services, in which case the risk lies with
the bank. Agency diversification implies an
institution acting as an agent: i.e. it uses its own
delivery systems to sell another institution’s
product or service. The advantages of an agency to
a firm is that it increases efficiency as it unlocks
complementary expertise, avoids some managerial
problems, avoids learning costs, generates fee-
income without balance-sheet constraints, and
allows firms to diversify without increasing
industry capacity in the new area.
• Finance versus non-finance companies:
Diversification can take place either within the
financial sector (e.g. banks diversifying into
insurance) or between commercial (i.e. non-
financial) companies and financial institutions.
This amounts to the issue of whether, for business
or regulatory reasons, finance should be regarded
as an exclusively specialist activity. In most
countries, there is a traditional distinction between
finance and non-finance companies, although to a
limited extent this is breaking down. Allowing
non-finance companies to own banks could offer
the advantages of diversification and widen the
sources of finance, such as insured deposits. It
potentially widens the scope of the central bank’s
lender-of-last-resort function. Also the question
arises as to whether it is appropriate for
unregulated and unsupervised commercial
51
 companies to own banks, or that a bank within a
holding company could be used to supply cheap
loans to other parts of the group. In particular, the
commercial company may be motivated by a desire
to gain access to insured deposits. Competitors to
firms who own banks might also be able to claim
that the bank owner had privileged access to bank
loans and even that they were being denied bank
credit for competitive reasons.
• Diversification versus ownership: The issue of
separation versus integration relates to the range
of allowable business and to the extent of
interlocking ownership structures both within the
finance sector (e.g. whether the bank can own an
insurance company) and between financial
institutions and non-finance companies. These are
distinct and separate issues. For instance, while in
the UK Marks and Spencer has a banking licence
and sells financial services, it is open to
considerable doubt at this stage whether the
authorities would allow it to purchase an existing
clearing bank12 or an insurance company.
• Management and capitalisation: This issue, in
the event that diversification into major new and
Table 4.8: Impact of regulatory restrictions on functional activity
Favourable
• Simplifies supervision as institutional and functional
activity merge
• Creates fire walls between different functional
activities and thus reduces systemic risk – ultimately
it is an institution, not a function, that becomes
bankrupt
• Lowers regulatory costs of supervision as, for
instance, the supervision of deposit-taking activities
or the granting of bank-deposit insurance is clearly
separated from the other activities of a financial
conglomerate
• One way of guarding against conflict of interest
problems
52
different areas is allowed, relates to the extent to
which the different functional areas can be
managed and capitalised in an integrated manner or
whether integration by ownership is allowed while
the management and/or capitalisation has to be
kept separate. The latter is one way of handling the
potential conflicts of interest involved in
conglomeration and avoiding the risks of
contamination, although by the same token it
denies economies of scale in the use of capital and
may impede marketing and delivery strategies.
3.1.4 Jurisdictional constraints
Most restrictions on domestic jurisdiction have been
eliminated over time and replaced with appropriate
capital requirements (e.g. if agricultural loans are more
risky than loans in the urban areas, a higher capital
requirement is stipulated for such loans rather then
prohibiting this type of business for certain financial
institutions13). Even in the United States restrictions on
12
A clearing bank is generally understood to be a major participant
in the inter-bank payment and settlement system.
13
For instance, in terms of the 1965 Building Societies Act,
permissible business for building societies was restricted to urban
areas in South Africa.
Unfavourable
• Reduces competition and business efficiency
between financial institutions. Limits competition
from smaller firms in particular
• Benefits non-financial institutions as the regulatory
constraints are often not applicable to them
• Firms use capital and human resources less
efficiently (every subsidiary needs its own
management and capital resource)
• May increase risk via enforced concentration of
business
• Reduces regulatory flexibility as countries have to
harmonise their regulation fully in some respects
(because the same client can be served from
different countries)
• Impedes responses to changes in business conditions
• Reduces the benefits of economies of scale and scope
Financial Regulation in South Africa: Chapter 4
interstate banking are no longer as vigorously enforced
as in the past. However, in many developing countries,
exchange control regulation remains a serious barrier
for firms wanting to expand globally.
3.1.5 Pricing constraints
Although free competition primarily implies pricing
freedom, regulators may still impose pricing
restrictions or condone private pricing cartel
agreements (e.g. on setting interest rate ceilings by
banks or fixed-brokerage charges). In these cases the
authorities balance reduced price competition against
reduced systemic risk, particularly in an economic
environment where price competition can become
“cut-throat” or “excessive”.
Restricting price competition (i.e. condoning price
cartels) creates economic rents (and hence either high
costs or profits), which go against consumers’ interests.
However, in this way business risk may be reduced to
the extent that profits can be earned without moving
into high-risk areas. In terms of the target-instrument
approach to financial regulation, price competition
should be promoted (to the benefit of the consumer),
while the resulting systemic risks have to be addressed
in other ways (e.g. capital-adequacy rules).
3.1.6 Operational constraints
Operational constraints embrace a wide field of
regulatory restrictions. In this section attention is given
to the following major requirements: prudential
requirements; business conduct requirements; trading
requirements; and compensation scheme requirements.
Prudential requirements
The key to financial stability lies ultimately with the
institutions themselves and in particular on their risk
analysis, management and control systems. The most
Table 4.9: Impact of regulatory restrictions on jurisdiction
Favourable
• May limit risk exposures of firms
• May support national economic policies (particularly
the balance of payments, but ultimately fiscal and
incomes policies)
Financial Regulation in South Africa: Chapter 4
effective supervision, ultimately, begins at home. For
this reason the prudential requirements for capital and
liquidity are considered to be the backbone of any
regulatory regime. These balance-sheet constraints –
which are imposed on a consolidated basis14 for a
financial conglomerate – are aimed at addressing the
problems emanating from increased domestic
competition (banks versus non-banks, and financial
versus non-financial institutions), globalisation,
financial innovation and deregulation.
In general, equity capital is needed for the following
reasons:
• To absorb operating losses while enabling the firm
to stay in business;
• to support the basic infrastructure of the business
on the grounds that it would be inappropriate for
this to be financed by borrowed funds (e.g.
deposits or term loans);
• to maintain public confidence through an
indication that shareholders are prepared to make
funds permanently available to support the
business;
• to enable a firm to absorb risks and sustain shocks
while continuing to operate;
• to enable assets to be written off while still
maintaining solvency;
• to provide long-term funds to mitigate the hazards
of maturity transformation;
• to buy time to enable an institution to adjust to
changing market conditions and patterns of business.
14
This to avoid “double gearing” within a bank-insurance group.
However, it is still questioned whether it is feasible to have a
single consolidated capital requirement for a bank-insurance
group, or whether the capital invested by the parent company
(bank or insurance) in the affiliate has to be totally or partially
deducted from the parent's own funds, before the calculation of
the parent's capital requirement.
Unfavourable
• Reduces competition and market efficiency
• Increases risk as it forces a geographic concentration
• Segments markets geographically
53
 In this framework, capital has to exhibit three
essential characteristics: be permanently available;
have the capacity to absorb losses and asset write-offs
(hence the emphasis in regulation on equity rather than
debt capital); and there should be some positive
correlation between the level of capital and the degree
of risk in the business15. In this last respect an
institution can be burdened with too much capital as
well as suffering from too little. In effect, capital is
analogous to an internal insurance fund to provide
cover for various non-insurable risks not covered in a
firm’s pricing (i.e. unanticipated risks). Anticipated
risks should always be incorporated into a firm’s
pricing (i.e. in the risk premium charged).
Ultimately, stronger capital standards not only
improve the cushion for the absorption of losses, but
15
The capital-adequacy requirements for transactions on a
regulated exchange are usually lower than for OTC transactions,
as clearing and settlement systems on an exchange may be less
risky than in the OTC markets.
Table 4.10: Impact of capital adequacy requirements
Favourable
• Curtails excessive financial gearing, but otherwise
grants greater freedom to market participants, which
improves competition
• Promotes a level playing field between financial
institutions and between formal and OTC markets
(i.e. similar capital requirements for similar risk
exposures)
• Seems the only way to supervise financial
conglomerates such as universal banks
• Reduces cross-market risk and thus enhances
systemic stability
• Simplifies regulatory structures and procedures, in
turn reducing regulatory costs
• Ensures at least some compensation out of
shareholders’ funds for prejudiced investors/depositors
• Supports harmonisation with internationally agreed
minimum standards (IOSCO and Basel Agreements)
• Imposes capital-market discipline
• Enhances public confidence
• Enables banks to absorb risks
54
also shift part of the burden of supervision away from
the authorities onto the market.
In addition to adequate capital resources, the
authorities also need to ensure that financial
institutions, particularly banks, are not “asset rich, but
cash strapped”. Accordingly, banks are subjected to
strict liquidity requirements, such as cash reserve
requirements. In times of unexpected liquidity needs,
banks may supplement their liquidity by means of the
accommodation and lender-of-last-resort facilities of
the central bank. These standby arrangements of the
central bank will be discussed in greater detail in
Chapter 5, Sections 3.4 and 3.5.
Market conduct of business requirements
The imposition of principles and core rules for the
conduct of financial services business is aimed at
providing an adequate level of investor protection and
reducing regulatory costs. The underlying philosophy
of this requirement is that the various codes of
business conduct, as developed for each industry,
Unfavourable
• Raises the entry costs and thus may reduce
competition from small firms
• Raises the running cost of the business, as capital
has to be serviced by dividend payments
• Gives securities markets and non-financial
institutions a competitive advantage over financial
intermediaries
• May result in suboptimal portfolios if capital ratios
are not based on actuarially sound risk evaluations
(e.g. public sector securities often have too low a
capital ratio compared with private sector securities)
• Changing capital ratios will result in portfolio
adjustments, which may be swift, substantial,
potentially unstable and difficult to moderate
Financial Regulation in South Africa: Chapter 4
should provide adequate protection only, and should
not be excessively cumbersome.
For example, a three-tier system of conduct
regulation was developed for the UK investment
business as follows:
• The first tier consists of (10) broad principles
which all financial firms have to abide by. The
chief executive of a firm is directly responsible for
ensuring that the principles of investment business
are complied with (see Table 4.12). The authorities

Table 4.11: Impact of conduct of business conduct requirements

Favourable Unfavourable
• Allows for an inexpensive and expeditious way of • Undermines the authority of the regulator if not
solving legal disputes on issues such as prejudiced forcefully enforced
investors • May involve the authorities in lengthy (and costly)
• Supports self-regulation, which in essence centres legal battles
on best ethical standards and high-quality risk-
control techniques

Table 4.12: Principles for the conduct of investment business (in the UK)
• Integrity. A firm should observe high standards of integrity and fair dealing in the conduct of its business.
• Skill, care and diligence. A firm should act with due skill, care and diligence in the conduct of its business.
• Market practice. A firm should observe high standards of market conduct. It should also, to the extent
endorsed for the purpose of this principle, comply with any code or standard as in force from time to time and
as applied to the firm either according to its terms or by rulings made under it.
• Information about customers. A firm should seek from customers it advises or for whom it exercises
discretion any information about their circumstances and investment objectives which might reasonably be
expected to be relevant in enabling it to fulfil its responsibilities to them.
• Information for customers. A firm should take reasonable steps to give a customer it advises, in a
comprehensible and timely way, any information needed to enable him to make a balanced and informed
decision. A firm should similarly be ready to provide a customer with a full and fair account of the fulfilment of
its responsibilities to him.
• Conflicts of interest. A firm should either avoid any conflict of interest arising or, where conflicts arise, should
ensure fair treatment to all its customers by disclosure, internal rules of confidentiality, declining to act, or
otherwise. A firm should not unfairly place its interest above those of its customers and, where a properly
informed customer would reasonably expect that the firm would place his interests above its own, the firm
should live up to that expectation.
• Customer assets. Where a firm has control of or is otherwise responsible for assets belonging to a customer
which it is required to safeguard, it should arrange proper protection for them, by way of segregation and
identification of those assets or otherwise, in accordance with the responsibility it has accepted.
• Financial resources. A firm should ensure that it maintains adequate financial resources to meet its
investment business commitments and to withstand the risk to which its business is subject.
• Internal organisation. A firm should organise and control its internal affairs in a responsible manner, keeping
proper records, and where the firm employs staff or is responsible for the conduct of investment business by
others, should have adequate arrangements to ensure that they are suitable, adequately trained and properly
supervised and that it has well-defined compliance procedures.
• Relations with regulators. A firm should deal with its regulators in an open and co-operative manner and
keep the regulator promptly informed of anything concerning the firm which might reasonably be expected to be
disclosed to it.

Financial Regulation in South Africa: Chapter 4 55

 can discipline a firm if it does not apply the
principles, but no prejudiced investor can sue a
firm for not complying with a principle.
• The second tier consists of (40) designated rules,
which are derived from the ten principles. The
designated rules have more substance than the
principles, but are still more simplified than the
detailed rules contained in the rulebooks. A private
investor could sue his adviser if the latter breaks a
designated rule.
• The third tier consists of the rulebooks of the self-
regulatory organisations (SROs), which have to
incorporate all the designated rules (though the
authorities are prepared to make exceptions).
This three-tier system is less bureaucratic, less
legalistic in nature, and therefore less costly. However,
it assigns more responsibility to the SROs for policing
their own affairs with the principles in mind. Despite
being less legalistic, the system is not necessarily less
effective. Indeed, it would be easier for the Financial
Services Authority (FSA) to fine or to punish
offenders for not complying with a principle, than for a
technical infringement. Moreover, anyone who is not
prepared to accept the FSA’s interpretation of the
principles will have the right to take the FSA to a
public court resulting in costly legal proceedings.
Trading requirements
Of importance in this area has been particularly the
single-capacity trading requirement. In practice the
benefits of single-capacity trading were closely tied to
unlimited liability membership of an exchange and a
fixed-brokerage system. As global competition has
rendered these two restrictive trade practices increasingly
impractical, single-capacity trading is likewise
Table 4.13: Impact of single-capacity trading requirement
Favourable
• A cheap and efficient way of protecting the investor
against trade manipulation provided this trading rule
is rigorously applied.
• Easier to guard against conflicts of interest
56
disappearing. Today the issue is how to properly regulate
dual-capacity trading rather than to require single-
capacity trading16. This is done, for instance, by
introducing automated trading systems with good audit-
trail technology and surveillance programmes.
Moreover, as the concentration of power becomes
greater, there is more force to the argument in favour of
opening up an exchange (allowing negotiable brokerage,
corporate membership and ultimately dual-capacity
trading). During the last decade, competition between
securities exchanges in particular has grown fiercely,
with major securities often quoted simultaneously on a
number of exchanges. In addition, there has been
intensified competition from fully automated trading
systems or rival systems such as share dealing, trade
settlement and information gathering.
Compensation schemes requirements
Compensation schemes are a useful instrument for
protecting the small investor (see Table 4.14).
Government can be involved in a compensation
scheme either by being party to the scheme or by
regulating the scheme (i.e. laying down the regulations
and supervising the scheme). Compensation schemes
of sufficient size are usually required for regulated
exchanges to protect the interests of the small investor.
Moreover, in situations where netting arrangements
are not legally enforceable, the authorities can still
allow offset on a regulated exchange if the overall
exposure risk is covered by an approved compensation
scheme. Here compensation schemes significantly
16
Only under certain explicit conditions is dual-capacity trading
prohibited today (e.g. the Chicago Mercantile Exchange bans
dual trading in all contract months reaching the level of "maturity
liquidity" as determined by the exchange).
Unfavourable
• Today an unnecessarily restrictive requirement, as
an automated trading system can obtain the same
degree of investor protection as a single-capacity
trading rule
• Reduces competition (e.g. a financial conglomerate
can operate in dual capacity only)
Financial Regulation in South Africa: Chapter 4
contribute to market liquidity, as without them
financial gearing would be significantly lowered.
Bank-deposit insurance is a form of compensation
scheme. The authorities are in favour of these
schemes, but during the 1980s some serious
reservations developed (see Table 4.15). There is a
fundamental dilemma in deposit-insurance schemes in
that, where a 100% cover is offered, a moral hazard is
created in two respects. Firstly, the insured institution
may be induced to take excessive risk, especially when
its capital position is weak. If the risk does not
materialise, it gains the profits, but if the risk does
materialise, the cost is passed to the insurance fund.
This creates a one-way option for high-risk strategies.
In addition, the institution does not need to pay a
higher rate of interest to fund high-risk assets.
Secondly, the depositor has less incentive to take care
in the selection of institutions at which to make
deposits. By contrast, if coverage is less than total, the
scheme may be ineffective: for instance, depositors
will withdraw funds even if they stand to lose only a
small proportion of their deposits in the event of an
Table 4.14: Impact of compensation scheme requirement
Favourable
• The structural and procedural aspects of investor
protection are formalised, and arbitrary actions are
not needed – given that the relevant aspects have
been properly and adequately considered
• Forces a proper risk assessment, as the
compensation fund cannot accept a limitless
responsibility for investor protection
• Affords the government the scope for providing more
or less concisely defined guarantees – given that the
rules of the game are well publicised – and does not
expose it (and the taxpayers) to assumed or
imagined unconditional guarantees
• Greater stability can be created for the financial
system if investors, who do not have the capability to
do adequate risk assessment, are given greater
certainty about or at least an assurance of the safety
of their investment
Financial Regulation in South Africa: Chapter 4
institution’s collapse. Central bankers are still divided
over the benefits of deposit insurance. Those who have
great confidence in the market process and the ability
of banks to measure their risk exposures are usually
against deposit insurance17, whereas those who feel
that market imperfections cannot be ignored are in
favour of such insurance.
Private bankers often see mandatory deposit
insurance as an unwanted interference with major
moral hazard risks attached to it. Therefore, they feel
there is no need whatsoever for deposit insurance,
provided the central bank knows how to deploy its
lender of last resort and lifeboat facilities.
Another view is to see deposit insurance at the heart of
bank regulation. This position is likely to be adopted by
regulators, because they see a deposit-insurance scheme
as one of two fundamental methods to determine the
17
According to the Governor of the Reserve Bank of New Zealand
all that is required is: a sound monetary policy to temper
fluctuations in asset prices (enforced by positive real interest rates);
adequately capitalised banks (Basel Agreement); tough quarterly
disclosure rules; six-monthly audits; and a rating certificate of a
recognised rating agency on the front door of the bank.
Unfavourable
• Provides the scope for a firm to take on higher risk
business (as in the case of failure the claims against
it can be devolved onto the compensation fund)
• Can induce moral hazards with investors, as it
removes the incentive to consider the risks
involved in either a certain type of investment or a
specific institution
• Leads to cross-subsidisation where financially
stronger Institutions are continually paying for
weaker institutions with respect to the guarantees
(or the support) provided by the compensation
scheme (i.e. the free-rider problem)
• Although an upper limit is often provided, it is still an
open question as to whether there is an implicit
undertaking over and above that limit for the
government to provide investor protection
• Legal challenges can be issued to compensation
schemes arising from the fact that not all projected
risks are covered
57
 Table 4.15: Impact of bank-deposit insurance requirement
Favourable
• Lowers exit costs and thus may help to reduce
excess capacity in banking
• Affords at least some protection to retail investors
• Enhances stability of banking system by reducing
the likelihood of runs on healthy banks
• Role of taxpayer is explicitly taken into consideration
(i.e. in contrast to the lifeboat facility of the central
bank)
• The oligopolistic structure in banking may become
monopolistic if bank failure is not avoided
• Simplifies the lifeboat facility of the central bank
58
Unfavourable
• Overall risk in the banking industry could increase
(e.g. a 100% cover always creates a moral hazard
problem)
• The bank’s internal control and risk management
systems (the first line of defence) may be neglected,
while depositors may become indifferent to the
credibility of individual banking firms
• Large banks are in effect subsidising small banks
• The cost-benefit can be unfavourable (e.g. the US
experience). As a result of the higher cost structure of
banking in general, healthy banks are bound to lose
business to securities firms in the capital markets
• A bank that is part of a large financial conglomerate
needs no insurance, as financial assistance would
be forthcoming from within the group
• To run deposit insurance on sound actuarial
principles is difficult in a country (such as South
Africa) where a few big banks control more than
80% of the retail banking business
• Financial engineering makes it difficult to draw the
line at protecting some deposits and not others
• Limits imposed on the extent of deposit insurance
may be too low for the poor and also not prevent
bank runs
• Deposit insurance is a cure after a crisis – better to
prevent the crisis by proper bank supervision
• The local insurance capacity of the banking and
insurance sectors may be too small to cover this risk
(e.g. the Norwegian experience)
• Creates the political dilemma of how to determine
the premium (i.e. based on the size of the bank, the
actuarially calculated risk value, or a fixed-price
insurance)
• “Creative destruction” in the sense of efficient
institutions superseding obsolete ones, may be
restricted
Financial Regulation in South Africa: Chapter 4
capital adequacy of banks18. Indeed in theory, a bank’s
capital need can be determined either externally or
internally, i.e. either (i) by an external credit-rating
agency which, in effect, sells the bank a call option that
can be exercised should the bank be unable to repay its
depositors out of normal cash flows;19 or (ii) by the
bank’s internal risk-management models. In practice,
many countries make use of both these methods, but
with more emphasis on either the one or the other.
Usually the better the internal risk management systems
of a bank, the lesser the need to rely on rating agencies,
as there is less chance that use will be made of such a
deposit-insurance scheme. In the extreme, there will be
no need at all for deposit insurance, provided banks have
superior in-house risk management systems; the
authorities impose a Structured Early Intervention and
Resolution regime on banks20; and the investing public
obtains sufficient and timely information about the
quality and risk profiles of the banks (either from rating
agencies or the central banks).
However, it is mainly due to the lack of perfect and
costless information that there is a need for some form
of deposit insurance. If a bank runs into difficulties, e.g.
through unexpected exposure to bad debt it is often
difficult for the management to determine the precise
borderline between a temporarily illiquid position and
permanent insolvency. Likewise, the bank supervisors
may have great difficulty in obtaining timeously all the
relevant information about the state of solvency of a
bank. Moreover, even if the bank supervisors had
perfect information, they might not always be able to
disclose such information to the investing public, as
this may result in a run on the bank, which the
authorities are trying to avoid in the first place. For
depositors in general (i.e. outsiders not privy to any
18
A capital adequacy requirement flowing mainly from the inherent
risks that banks run by accepting deposits from the public with the
promise to redeem them on demand at par value plus interest.
19
The call option is then hedged by the rating agency with the
available funds in the deposit-insurance scheme, while the call
option price – i.e. the insurance premium – is based on the
actuarial risk assessment.
20
Such a regime will discourage inter alia forbearance by the
supervisory authorities.
Financial Regulation in South Africa: Chapter 4
sensitive and confidential data), obtaining reliable and
timely information is often a hopeless task.
3.2 Official monitoring and supervision
Financial institutions and markets have to subject
themselves to inspections by the regulatory
authorities. This regulatory instrument flows directly
from the licensing system, which underlies the
financial system. In the extreme, business licences can
be withdrawn if the authorities are dissatisfied with
what they see in practice.
Official inspections can take various forms. For
instance, financial institutions are usually requested to
submit, at regular intervals, specific financial
information21, which is then analysed by the regulatory
authorities with a view to spotting undesirable
developments, such as potential default trends.
In addition, financial institutions are subjected to on-
site spot inspections in which case the authorities
undertake a type of external audit of the company, but
with special reference to the prudential and conduct-
of-business requirements. To enhance the link between
the supervisors and the board of directors, the
authorities may also engage in presentations to the
board on how their firm compares with the industry at
large, or to air concerns of a more general nature. Ad
hoc interviews with non-executive directors may also
be required, particularly if the firm has problems in the
area of corporate governance.
Following the development of global financial
conglomerates during the 1990s, it has become
virtually impossible to monitor and supervise complex
groups properly on an ad hoc basis by various national
specialised agencies (such as bank or insurance
supervisory agencies in isolation). Accordingly the
modern trend is to supervise these groups by using
multi-disciplinary teams (bank, securities and
insurance experts from both home and host regulators,
all working in the same team) on a permanent basis
and located at the financial conglomerate’s head
21
Such as the official returns, which for an average bank may run
into hundreds of pages each month.
59
offices. This implies that the monitoring and
supervision are undertaken by one inspection team
(usually some 3–5 persons) who keep close contact
specifically with the risk management department,
audit department and the compliance office.
3.3 Intervention and sanctions
In the banking sector, rather than using scarce
regulatory resources to manage a bank deposit-
insurance scheme, these resources could be used,
alternatively, to prevent a banking crisis by means of
Structured Early Intervention and Resolution
arrangements (or SEIR arrangements).22 The
underlying idea of these SEIR arrangements is that the
authorities have to make sure that there is always
enough equity capital in the firm to repay the
depositors and secured creditors in case of insolvency.
The essence of a SEIR strategy is that trouble within a
bank usually builds up over time rather than suddenly
emerges without notice. Thus under SEIR certain
trigger points (e.g. related to a banks capital adequacy
levels) are established and as a bank passes through
each stage, mandated corrective action is required from
the supervisor. The action taken at each stage may be
relatively minor in itself but cumulatively becomes
significant as each stage is passed. Ultimately, the bank
is closed before it has become insolvent. A major
feature of SEIR proposals is that supervisory
intervention is mandatory: i.e. there is no discretion.
Accordingly, with this instrument the authorities
subject the regulated institutions to a stringent regime
of timely provisions against doubtful and bad debts. As
these debts mount during the normal course of the
business cycle, the credit risks are already impaired
against capital, implying that shareholders would have
to purchase additional ordinary shares if surplus capital
is not available. If the shareholders are unwilling to
invest further resources in a troubled institution, the
authorities could immediately take the necessary steps,
such as a prohibition on paying dividends or on
22
A properly Structured Early Intervention and Resolution process
might imply no need for deposit insurance at all.
60
expanding the business by taking on more assets on to
the book, or they could even close the institution. By
their nature SEIR arrangements are crucially dependent
on the timely assessment of risks and on the political
will to close (potentially) insolvent institutions.
An uncommon form of intervention in the banking
industry is found in South Africa where banking
legislation (section 89 of the Banks Act of 1990)
contains a provision which enables the regulator, at the
request of the directors of a distressed bank, to place
the bank under curatorship. The main advantage of
such an action is that the curator has, among his
extensive powers, the ability to “freeze” deposits and
halt a run on the bank while he searches for an
appropriate solution in the best interests of depositors.
The curatorship provisions are controversial and to a
large extent untested in law. There are proposals on
extensively amending the Banks Act in South Africa
in this regard, and proposals have also been made to
scrap the curatorship provisions altogether. The
probable advent of deposit insurance in South Africa is
also used as an argument for the review of the
curatorship provisions. The curatorship provisions
have been misunderstood and possibly misapplied in
the past. However, in the situations in which they have
been used, they were used effectively to prevent the
inevitable run on the bank concerned from
deteriorating into a “fire sale” of assets in order to
meet depositors’ demands. Such fire sales result in a
much worse situation for all depositors, or prejudice
those depositors, usually the more unsophisticated
ones, who did not react in time to the bank’s distress.
Deposit insurance will not alter the situation because,
in order to avoid moral hazard, deposits will never be
fully insured and if depositors stand to lose even a
small percentage of their deposits, they will still create
a run on the bank.
In the financial markets of many countries, the
detection of price manipulation and unfair or insider
trading practices is increasingly becoming subject to
intervention by the authorities. Using the information
from the trading system, legislation can give the
authorities investigative powers including rights of
Financial Regulation in South Africa: Chapter 4
attachment, removal of documents, interrogation and
interdict and the power to institute derivative action.
The authorities are able to bring civil action to bear
against the transgressors so as to claim special
damages from them or, in special circumstances, from
their employers or principals. Persons who have
suffered loss as a result of unfair trading may also be
able to claim compensation.
3.4 Incentive contracts and structures
Incentive structures and moral hazards faced by
decision makers (bank owners and managers, lenders
to banks, borrowers and central banks) are major
issues to consider in the regulatory regime. Some
analysts ascribe much of the recent banking crises to
various moral hazards and perverse incentive structures
such as fixed exchange-rate regimes, anticipated lender-
of-last-resort actions, what are viewed as bailouts by the
IMF, the ownership structure of banks and their
corporate customers, and safety net arrangements.
Incentive contracts can cover a whole range of financial
activities. At the top of this list are the incentives to
ensure proper corporate governance (which will be
discussed in more detail in Section 3.6 below). If a firm
has a good corporate governance culture, a host of other
regulatory requirements will automatically fall into
place, such as a proper compliance culture and adequate
risk-management systems.
The ultimate aim of incentive contracts is to replace,
or supplement, a one-size-fits-all official dictate with a
specific, tailor-made corporate contract that
acknowledges the firm’s own responsibility for sound
business practices. For example, the compliance
manual of each individual firm can be seen as an
incentive contract. In a similar vein, financial firms
may be offered a choice by the authorities either to
fulfil a fixed-ratios prudential requirement23, or to
replace this inflexible standard with its in-house value-
at-risk model to calculate its statutory capital
requirement. This section will address these two issues
in somewhat greater detail.
23
This is the “building block” approach, which applies to all firms
without adjustments for institutional specifics.
Financial Regulation in South Africa: Chapter 4
Capital regulation should create incentives for
the correct pricing of absolute and relative risk
If differential capital requirements are set against
different types of assets (e.g. through applying
differential risk weights), the rules should be based on
actuarial calculations of relative risk. If risk weights
are incorrectly specified, perverse incentives can be
created for firms because the implied capital
requirements are more or less than those justified by
true relative risk calculations. A major critique of the
current Basel capital requirements for banks is that the
risk weights bear little relation to the relative risk
characteristics of different assets, and the loan book
carries a uniform risk weight even though the risk
characteristics of different loans in a bank’s portfolio
vary considerably.
Incentives for owners
The owners of financial institutions have an important
role in the monitoring of management and their risk
taking. Essentially, it is owners who absorb the risks of
the firm. There are several ways in which owners can
be given appropriate incentives:
• One route is to ensure that firms have appropriate
levels of equity capital. Capital serves three main
roles as far as incentive structures are concerned:
(i) it commits the owners to supplying risk
resources to the business, which resources they can
lose in the event that the firm makes bad
investments or loans; (ii) it is an internal insurance
fund; and (iii) it wards off the danger that the firm
may become the captive of its bad clients or
debtors. In general, the higher the capital ratio, the
more the owners have to lose and hence the greater
the incentive for them to monitor the behaviour of
managers. Low capital creates a moral hazard in
that, given the small amount owners have to lose,
they are more likely to condone excessive risk
taking in a gamble-for-resurrection strategy. This
was evidently the case during the Savings and
Loan crisis in the United States.
• Corporate governance arrangements should be such
that equity holders actively supervise managers.
• Supervisors and safety net agencies should ensure
61
 that owners lose out in any restructuring operations
in the event of bank failure. Failure to penalise
shareholders in the restructuring of unsuccessful
banks has been a major shortcoming in some
rescue operations in Latin America.
• In some countries (e.g. New Zealand) the incentive
for owners has been strengthened by experimenting
with a policy of increased personal liability for
directors of firms.
Incentives for management
Creating the right incentive structures for the managers
of financial institutions is equally as important as
creating those for the owners. In fact, the two should
be seen in combination. Ultimately, all aspects of the
behaviour of a firm are corporate governance issues.
There are several procedures, processes and structures
that can reinforce internal risk control mechanisms.
These include internal auditors, internal audit
committees, procedures for reporting to senior
management (and perhaps to the supervisors), and
making a named board member responsible for
compliance, risk analysis and management systems.
Supervisors can strengthen the incentives for these by,
for instance, relating the frequency and intensity of
their supervision and inspection visits (and possibly
rules) to the perceived adequacy of the internal risk-
control procedures and compliance arrangements. In
addition, regulators can create appropriate incentives
by calibrating the external burden of regulation (e.g.
number of inspection visits and allowable business) to
the quality of management and the efficiency of
internal incentives.
Specific measures designed to create correct
incentive structures include the following:
• Strong and effective risk analysis, management and
control systems in place in all financial institutions
for assessing risks ex ante, and asset values ex post.
For banks, this includes systems and incentives for
timely and accurate provisioning against doubtful
or bad debts. Many bank failures are ultimately due
to weaknesses in this area. Regulatory agencies
have a powerful role in promoting, and insisting
upon, effective systems of internal management
62
and risk control in financial institutions through the
strict accountability of owners, directors and senior
management.
• Managers should also lose if the institution fails.
This requires a high degree of professionalism in
the firm’s managers and decision makers and also
penalties (including dismissal) for incompetence
among managers. Remuneration packages may be
related to regulatory compliance.
• Subject to prudential standards being maintained,
proper incentives can be created by fostering
competition in the financial sector. This can be
achieved, for instance, by removing restrictions on
business activity, allowing the entry of foreign
banks and other financial institutions, and forcing
the abandoning of restrictive practices, cartels and
other anti-competitive mechanisms.
• Mechanisms need to be in place to ensure that loan
valuation, asset classification, loan concentrations,
interconnected lending and risk assessment
practices reflect sound and accurate assessments of
claims and counterparties. This also requires
mechanisms for the independent verification of
financial statements and compliance with the
principles of sound practice through professional
external auditing and on-site inspection by
supervisory agencies.
• Ownership structures that foster shareholder
monitoring and oversight. These structures include
private ownership of firms to strengthen the
monitoring of management performance and to
reduce distortions in incentives for managers.
• Requiring large financial firms to establish internal
audit committees.
The key is that there needs to be appropriate internal
incentives for management to behave in appropriate
ways. And the regulator has a role in ensuring that
internal incentives are compatible with the objectives
of regulation.
Incentives to create a sound compliance culture
Regulation is often too legalistic, with too little
supervision. Frequently the appropriate regulatory
structure is in place, but is not backed up by adequate
Financial Regulation in South Africa: Chapter 4
supervision (e.g. the BCCI and Barings cases in the
UK). The supervision of wholesale investment business
has to be undertaken primarily through self-regulatory
organisations, while retail investment business has to
be supervised more extensively by resorting to
compliance procedures, adequate disclosure standards,
random spot examinations, detailed reporting by
external auditors and published ratings by rating
agencies. To address all these issues, compliance and
data examination processes are necessary.
Today most industrialised countries make explicit
compliance office structures a requirement for
financial institutions. In terms of this arrangement,
every financial institution has to submit a detailed
compliance manual to the authorities for approval.
This compliance manual can be seen as an incentive
contract between the regulated and the regulator.
Therefore it is bound to be more voluminous for more
complex businesses.
Typically the compliance officers have to pay
specific attention to the following aspects:
• Safeguarding the reputation and image of the
institution.
• Training and competence.
• Transparency and disclosure.
• Standards of advice.
• Suitability of products for specific customers.
• Conflicts of interest.
• Fraud and money laundering.
Compliance with regulations has to follow the spirit
and purpose of the rules and not merely staying within
the “letter” of the rules. For instance, the compliance
officer of a firm should not opt for a mechanistic or a
“work to rule” approach, but aim at ensuring the “best
practice” application of the regulations. If effective
compliance does not take place, there could be
impaired judgements (e.g. underestimation of risks),
Table 4.16: Impact of compliance and data examination requirements
Favourable
• Improves risk management within firms
• Enforces ethical standards in firms
• Enhances the supply of reliable information
Financial Regulation in South Africa: Chapter 4
which may negatively impact on business efficiency
and consumer protection.
Data examination requirements increasingly demand
the centralisation of data (e.g. to measure overall
exposure – whether from a risk evaluation or capital
adequacy point of view) and the adapting and
integrating of existing computer systems. Obviously
these examination requirements place a financial strain
on firms. But it is a necessary expense, especially in
view of the risk exposures of today’s firms.
Incentives to contain systemic and
business risks
For over two decades risk management departments of
financial institutions have mushroomed – and not
without reason. Without proper risk management, no
bank or securities firm can stay in business, as it would
inter alia be unable to answer the many detailed
questions of the supervisors about topics such as
liquidity maturity ladders, repricing intervals and
value-at-risk.
Risk management has become a field of expertise
where high finance, advanced mathematics and
informatics are closely intertwined. Whether the
supervisors like it or not, they have become
increasingly dependent on the in-house risk
management and control systems of the institutions
they supervise, as the official inspection staff
represents only a fraction of the firm’s risk
management staff and their various technical support
functions. Accordingly, there is a self-interest on the
part of the authorities to encourage high quality risk-
management assessment techniques in financial
institutions on which the regulators can leverage their
own monitoring and control systems.
The major financial risks faced by a financial
institution are the following:
• Credit risk, which requires inter alia timely and
Unfavourable
• Increases entry costs and running costs of firms
63
 adequate provisions against doubtful and bad debt,
the correct pricing of risks, and correct loan and
asset valuation.
• Market risk, which rests primarily on value-at-risk
and earnings-at-risk assessment procedures.
• Liquidity risk, which necessitates extensive stress
testing of cash flow models.
• Operational risk, which entails, for instance, audit
arrangements, forensic investigations and
management control systems.
The essence of corporate risk management is the
management of overall institutional risk across all risk
categories and business units. Although in terms of the
current Basel capital standards, the statutory capital
adequacy of banks is still allowed to be determined by
means of the building block approach24, the modern
approach is very moving in the direction of Enterprise-
wide Risk Management (ERM). Financial market
dynamics make it increasingly difficult to consider the
various risk categories in isolation, as say a major
insolvency (credit risk) may give rise to a liquidity
crisis, in turn triggering a sharp fall in asset prices
(market risk). As risks are at times highly correlated,
the risk-management approach has to shift to a
portfolio approach. The need for an integrated process
for identifying, measuring and managing all risks of an
enterprise (in its global context) has necessitated the
ERM approach. In the end the ERM tries to address
the classic risk-management problem of how to
achieve (an always elusive) degree of leverage that
creates an adequate return on equity without
threatening default. Unfortunately the ERM approach
depends on having highly skilled staff and major
system backing. The ERM is therefore expensive.
Supervisors cannot duplicate these systems for their
inspection purposes, and neither is it in their interests
to stick to the old “building block” approach of
determining capital adequacy. Accordingly they have
to encourage financial institutions to follow ERM
modelling techniques, by means of specialised
incentive contracts.
24
Where the required capital for each risk category is considered in
isolation and then summed to a grand total.
64
3.5 Market monitoring and discipline
Besides official monitoring and supervision, the
financial markets also monitor the performance of
financial institutions. If markets are dissatisfied with the
performance of certain financial firms, their discipline
can be harsh and sudden. Usually, market discipline
works through the share price, the price of subordinated
debt, and willingness to trade with a firm. Particularly
for banks, where trust is the basis of all business, a
major fall in a bank’s reputation can be extremely
painful. On balance, the markets are far more successful
in enforcing a change in directors and management than
are the authorities. As virtually every bank failure has
had poor management as one of the underlying reasons,
it is in the interest of the authorities to promote market
monitoring and discipline to the maximum.
Market monitoring is only possible if there are
proper disclosure and transparency arrangements.
Transparency is supported if financial institutions
report in terms of generally accepted accounting
standards and external auditors report any misgivings
they may have. The rating agencies, the unsecured
creditors in the capital market and the financial press
are also important role players in ensuring market
discipline. Each of these role players will be briefly
discussed in this section.
Role of external auditors
There is a growing trend in financial regulation to
place more responsibilities on external auditors who
can potentially fulfil a valuable role in validating the
financial and other information used by the regulators,
and act as “whistle blowers” if they discover any
irregularities in the course of their examinations of the
financial institutions they audit.
However, external auditors are appointed and paid
by the financial institution’s shareholders and the
increasing demands on them from regulators create a
classic conflict of interest. Although in theory they are
appointed and removed by shareholders, in practice
this function is taken on by the financial institution’s
management and it is often the institution’s
management which external auditors are required to
criticise in their reports to regulators.
Financial Regulation in South Africa: Chapter 4
 It is clear that in any regulatory system where
additional responsibilities are assigned to external
auditors, it will also be necessary to take whatever steps
are necessary to avoid conflicts of interest and also to
strengthen the independence of the external auditors. A
number of models are available for this purpose, e.g.
compulsory rotation of external auditors (as in France).
Nonetheless, considering the assistance auditors could
render to the supervisors by reporting criminal activities
within a firm, it may be necessary to expand the areas
of auditors’ responsibilities. For instance, in the UK the
Bingham Report recommended that auditors should
have the duty, and not just the right, to inform the
authorities of adverse circumstances.
Moreover, financial conglomerates should have a
single, or at least the same, auditors for all the
financial companies of the group25.
25
After the BCCI experience it is recommended that all companies
in the conglomerate should have the same accounting date, and the
head office should be in the same country as its registered office.
Table 4.17: Impact of using rating agencies by the regulatory authorities
Favourable
• Improves information to investors in respect of debt
instruments and institutions by establishing an
independent comparative scale of investment risk
(“buy lists”)
• Investors use ratings to assess the risk premium of a
security
• Good ratings enable issuers to come to the market
quickly with new issues
• Good ratings can result in a saving in funding costs
• The existence of a pool of rated debt securities may
help to create a risk-based price structure in the
market
• Disseminated opinions about credit provide wider
access to investor capital
• Good ratings counteract the effects of rumours and
speculation
• Credibility of bank statements is tested
• An independent assessment
• Strengthens market discipline (e.g. through cost of debt)
* There usually are sufficient laws to prevent or to punish gross violations of conduct by the agencies, such as providing a
favourable rating in exchange for a secret payment.
Financial Regulation in South Africa: Chapter 4
Official recognition of ratings by private
credit-rating agencies
Rating agencies help to alleviate two central problems
in finance: asymmetric information and a lack of
expertise in assessing information. Ratings are based
not only on published information but also on
information that is normally only available to the firm
itself or a bank making a loan to the firm. Though
rating agencies do not disclose all of the information at
their disposal, it is embodied in the ratings issued. In
addition, rating agencies develop considerable
expertise in analysing information, especially since
their reputation in this field establishes the credibility
of their ratings.
In essence, a rating agency offers independent
opinions on the future risk of defaulting on debt
securities and related fixed-income obligations.
Depending on investor demand, opinions may be
offered on virtually any financial instrument or
obligation involving a promise to pay – such as
Unfavourable
• As firms are keen to obtain a good rating, rating
agencies may degenerate into “blackmail” agencies*
• Rating agencies are subject to strong competition
and, if they fail to provide the service for which they
are paid, clients will stop using them.
• Management may try to improve rating (short-term
goal) at the cost of firm’s long-term profitability
• Subjective analysis can lead to adverse ratings and
may distort the allocation of financial resources (“run
on a bank”)
• Investors may abdicate the responsibility for credit
risk assessment to the regulator that approves rating
agencies (“moral hazard problem”)
• The “accreditation” or regulation of rating agencies
may create an “implicit contract” in terms of which
the quality of a rating agency is no longer
determined by market forces
• If there is limited access to information, ratings may
be subjective
65
corporate bonds, preferred stock, commercial paper,
bank deposits, structured financing and the
policyholder obligations of insurance companies.
Regulators in many countries require ratings of
various classes of debt, for example:
• Chile – all issuers of public securities have to
obtain, at their own cost, ratings from at least two
distinct and independent chartered rating agencies.
• France – issuers of debt have to publish the rating
they obtained from a specialised agency.
• India – an issuer has to obtain a rating from an
agency approved by the central bank.
• Japan, the United Kingdom and the United States –
regulators use ratings to assign values to securities
held in inventory.
The rationale behind the regulators’ interest in rating
agencies is that a well-run rating agency system may
perform a number of quasi-regulatory market functions
at less cost to government – for example, by making
more information available and thereby promoting
prudent investment decision-making processes by
investors and/or depositors.
Clearly, once regulators have decided to make the
rating of debt mandatory, they have to decide whose
ratings are acceptable. Switzerland refers to
internationally recognised agencies, the United
Kingdom to authorised agencies and the United States
to nationally recognised statistical rating
organisations. Each country uses slightly different
methods to regulate or accredit rating agencies.
Assessment by the capital market
Acceptance and comparative assessments of financial
institutions through the international capital market
can be achieved by enhancing the position of
unsecured subordinated debt holders. To enhance the
power of foreign creditors in banks’ risk management
policy and to encourage more disclosure, the
authorities may stipulate that a certain percentage of
statutory capital should consist of foreign-currency-
denominated unsecured subordinated debt (i.e. third-
tier capital). In principle, at least, a number advantages
flow from this statutory requirement:
• The yield at which these securities trade in the
66
capital market will give the authorities and
depositors a good insight into the market’s
confidence in a specific institution. The yield can
be seen as a rating instrument.
• As the holders of uninsured subordinated debt are
far back in the line as creditors, they will pressure
management to stay within acceptable risk
parameters during their normal business and do
proper risk management assessment in general.
• Subordinated debt holders form a type of natural
counterbalance against ordinary shareholders, who
may gain from the resurrection strategies of
insolvent banks, while subordinated debt holders
can only lose from such high-risk strategies.
• As banks have a direct interest in the market’s
confidence, the issuing of subordinated debt
provides a powerful incentive for banks to improve
their disclosure policies and the transparency of
their accounts.
• Subordinated debt requirements are easy for
supervisors to verify, and so they can be held
accountable for verifying.
In practice, official supervision and regulation
cannot operate properly without any external market-
derived pressure. Market signals and market penalties
make government actions more credible and remove
the capacity of government officials to deny that a
problem exists. Whether they like it or not, financial
supervisors operate in a political environment and
have to be on their guard against (often well-intended)
forbearance. Forbearance is a major problem in
regulation, as in crisis after crisis supervisory agencies
have shown that although they did not lack
information, they did lack the political will to do what
they were created to do26. In regulation, transparency
is crucial, but in isolation it is clearly not enough.
Likewise, no supervisory agency can be created in
isolation that can serve as an effective substitute for
market discipline.
26
Calomiris, C., “Market-based banking supervision”, The
Financial Regulator, Volume 3, No 4, London: Central Bank
Publications, 1999, p.34.
Financial Regulation in South Africa: Chapter 4
A critical financial press
Market discipline would be very harsh indeed if
consumers were properly informed about badly
managed firms or dishonest market conduct by firms
(such as front running), and as a result of this insight
decide to do their business elsewhere. Unfortunately,
in practice, it is virtually impossible for the authorities
to inform the general public without the support of the
financial press and consumer bodies. In fact, the
authorities would do better to focus on these interest
groups exclusively and leave it to them to provide the
necessary disclosure to consumers.
Likewise, consumer education is best done with the
assistance of the financial press and consumer bodies.
Therefore it is also in the interest of the authorities to
take note of the specific requirements of these interest
groups and assist them, in turn, wherever possible with
timely and adequate information.
Fewer entry barriers
The market is unable to exert discipline effectively if
entry and exit barriers in the industry are too high.
To promote competition, and thus market discipline,
the authorities should try to lower these barriers
wherever possible.
Historically, regulation in finance has often been
anti-competitive in nature and the regulators
condoned, and in some cases endorsed, unwarranted
entry barriers. Today, less restrictive regulation,
particularly with respect to allowable business, and the
development of information and delivery technology
has lowered the entry barriers.
For instance, retail financial services firms (banks,
building societies, fund management institutions,
insurance companies, etc.) face increasing challenges
in this respect – they are losing some of their
comparative advantages which have underpinned their
dominant position in the financial system. In
particular, as entry barriers into the industry
decline, traditional financial firms are facing new
types of competition from a wider range of
competitors. In addition, the development of
electronic banking has in some countries enabled
foreign banks to enter hitherto relatively closed
Financial Regulation in South Africa: Chapter 4
domestic retail banking markets. All these forces
improve competition and hence market discipline.
3.6 Corporate governance
If a proper corporate governance regime is in place the
regulatory authorities need not be too prescriptive in
their codes of business conduct, as these requirements
are already “privatised” in the sense that they have
become supervisory tasks of the private rather than a
public sector. Corporate governance rules can be seen
as a form of market discipline: i.e. their standards are
set by international competitive forces.
Corporate governance is essentially about
leadership.28 More particularly, it is leadership for
efficiency, probity, responsibility, transparency and
accountability. Business efficiency is necessary to
compete in the global economy. Business probity is
required to obtain the trust of investors. Business
responsibility is increasingly considered as including
not only profitability but also legitimate social
concerns. Business transparency and accountability are
the essential characteristics of good leadership without
which there can be no trust in the leaders.
It is the responsibility of the board of directors to
ensure good corporate governance. This involves a set
of relationships between the management of a
corporation, its board, its shareholders and other
relevant stakeholders. Accordingly, the board must
agree on the corporation’s purpose (what it is for), its
values (what it stands for) and the strategy to achieve
its purpose. It must account to shareholders and be
responsible to its stakeholders.
Good corporate governance requires that the board
must govern the corporation with integrity and
enterprise in a manner that entrenches and enhances the
licence it has to operate. This licence is not only
regulatory but also embraces the corporation’s
interaction with its shareholders and other stakeholders.
Though the board is accountable to the owners of the
27
This section is based on the following report: Commonwealth
Association for Corporate Governance, CACG Guidelines,
Principles for Corporate Governance in the Commonwealth,
CACG Secretariat, Marlborough, New Zealand, 1999.
67
corporation (shareholders) for achieving the corporate
objectives, its conduct regarding factors such as
business ethics and the environment, for example, may
have an impact on legitimate societal interests
(stakeholders) and in this way influence the reputation
and long-term interests of the business enterprise.
Table 4.18 summarises the 15 principles of
corporate governance. These principles are not to be
regarded as legal statutes that are to be followed to the
letter – rather they represent standards of conduct,
which should be followed according to the spirit and
intention of the guidelines.
Empirical evidence seems to indicate that good
corporate governance nearly always goes hand in hand
with good companies and wealthy nations, whereas
bad governance is virtually synonymous with poverty.
This conclusion essentially confirms the old business
philosophy that the basis of wealth creation is
ultimately trust.

Table 4.18: Principles of corporate governance

The board should do the following:
• Exercise leadership, enterprise, integrity and judgement in directing the corporation so as to achieve continuing
prosperity and to act in the best interest of the business enterprise in a manner based on transparency,
accountability and responsibility.
• Ensure that through a managed and effective process, board appointments are made that provide a mix of
proficient directors, each of whom is able to add value and to bring independent judgement to bear on the
decision-making process.
• Determine the corporation’s purpose and values, determine the strategy to achieve its purpose and to
implement its values in order to ensure that it survives and thrives, and ensure that procedures and practices
are in place that protect the corporation’s assets and reputation.
• Monitor and evaluate the implementation of strategies, policies, the management’s performance criteria and
business plans.
• Ensure that the corporation complies with all relevant laws, regulations and codes of best business practice.
• Ensure that the corporation communicates with shareholders and other stakeholders effectively.
• Serve the legitimate interests of the shareholders of the corporation and account to them fully.
• Identify the corporation’s internal and external stakeholders and agree on a policy, or policies, determining how
the corporation should relate to them.
• Ensure that no one person or a block of persons has unfettered power and that there is an appropriate balance
of power and authority on the board which is, inter alia, usually reflected by separating the roles of the chief
executive officer and chairman, and by having a balance between executive and non-executive directors.
• Regularly review processes and procedures to ensure the effectiveness of its internal systems of control, so
that its decision-making capability and the accuracy of its reporting and financial results are maintained at a
high level at all times.
• Regularly assess the corporation’s or board’s performance and effectiveness as a whole, and that of the
individual directors, including the chief executive officer.
• Appoint the chief executive officer and at least participate in the appointment of senior management, ensure
the motivation and protection of intellectual capital intrinsic to the corporation, ensure that there is adequate
training in the corporation for management and employees and a succession plan for senior management.
• Ensure that all technology and systems used in the corporation are adequate to properly run the business and
keep it a meaningful competitor.
• Identify the key risk areas and key performance indicators of the business enterprise and monitor these factors.
• Ensure annually that the corporation will continue as a going concern for its next fiscal year.

68 Financial Regulation in South Africa: Chapter 4

3.7 Discipline on and accountability of
regulators
Subjecting the authorities to accountability and
discipline is, in essence, aimed at avoiding the danger
of inadequate regulation or over-regulation (which in
turn are symptoms of what is called state failure).
Market failures often centre on asymmetrical
information flows, monopolies and the domino effect
of financial failure (which may create systemic risks),
whereas state failures usually entail one or more of the
following shortcomings:
• Inability to enforce existing law.
• Inertia about bad law.
• “Regulatory capture” by industry or consumers.
• “Empire building” by the authorities.
• A lack of business efficiency on the part of the
authorities.
• Regulatory gaps.
It is often the case that market failure is cheaper for
the consumer than state failure. Therefore, if the
authorities are unable to address state failure
adequately, it is often better not to rely too excessively
on statutory regulation, but instead to lean more
heavily on market discipline or to follow a policy of
“regulation by reputation”. Indeed, firms are sensitive
to their reputation, and their fear of any adverse
publicity in the media (e.g. of any fines imposed) can
be an effective disciplinary instrument.
Three key issues usually come to the fore in any
discussion of the accountability of regulators: their
governance rules, their cost efficiency and their
willingness to co-operate with other regulatory bodies
and thus to harmonise their standards with
international best practice. Each of these issues will be
discussed briefly below.
Governance and the regulator
The governance problem is often compounded by
conflicts of interest between supervisors, investors,
depositors and taxpayers. In the case of public
guarantee funds, financial sector supervisors have no
similar financial stake to that of shareholders, who
have an equity exposure. Their compensation cannot
be readily tied to performance through the tools of
Financial Regulation in South Africa: Chapter 4
incentive contracts or equity ownership. Nor are
supervisory agencies subject to the threat of a
takeover. As a result, there is little no guarantee that
supervisors will always use their best efforts in the
interest of depositors, investors and taxpayers.28
When confronted with a bank in distress, supervisors
may find it difficult to proceed if the bank is “too big to
fail”29 or if powerful politicians are trying to protect the
bank. They may be reluctant to disclose bad news,
especially if the problem ought to have been discovered
earlier. Moreover, supervisors may often find that
friendly relations with bankers serve their long-term
interests better than a strictly arm’s-length relationship.
Bank supervisors have much discretion – for
example, with regard to the definition of insolvency or
the valuation of assets. A bank that is deemed insolvent
by generally accepted accounting standards may not be
insolvent in terms of the supervisors’ rules and vice
versa. Supervisors may not recognise changes in the
market value of assets or may not do so on a timely
basis. And if it serves their interests, supervisors might
delay the necessary regulatory action.
The Core Principles for Effective Banking Supervision
(see Box 4.1 later) have become one of the most
important global standards for prudential regulation and
supervision. A regulatory audit agency could assess the
current situation of a country’s compliance with the
Principles. Such an assessment should identify
weaknesses in the existing system of supervision and
regulation, and form a basis for remedial measures by
government authorities and the bank supervisors.
In the business of banking, time is literally money.
Delayed corrective actions typically mean larger losses
down the road. Troubled banks may respond to losses
by taking on more speculative investments in the hope
of making up for such losses. But this “desperation”
risk taking often only magnifies the losses.
28
Indeed, the widespread failures of public deposit guarantee funds
stand in stark contrast to the well-governed – and profitable –
business of private sureties, which provide credit guarantees on a
commercial basis.
29
The principle of “too big to fail” is refined at times to mean that
it is only the second bank in a financial crisis that is too big to
fail, but never the first to collapse.
69
 A solution to the above problems may be found in
establishing a regulatory audit agency, although
international experience in this area is still limited.
Governance issues for regulators will probably be
improved in a piecemeal manner in years to come. For
instance, of late the IMF has drawn up a Code for
Transparency in the Conduct of Fiscal Policy as well as
a Code for Transparency in the Conduct of Monetary
and Financial (implicitly regulatory) Policies. At stake
here is again the debate between “rules versus
discretion”, this time on how to subject even senior
officials to a code on how they should behave.
Cost of regulation (cost-benefit)
Correcting market failures comes at a cost, which is
justified only if the social benefits of regulation exceed
the social costs. If regulators ignore the cost
implications of their activities,30 state failures (as
opposed to market failures) seem virtually unavoidable.
Accordingly, it is of great importance to subject
proposed regulation to detailed cost-benefit analysis.
Experience has shown that financial regulation is
costly, both directly and indirectly (see Table 4.19).
30
Regulators have goals of their own, not always identical with the
goals of society. Power, prestige and income are liable to be
associated with the size of their agencies. All of this would raise
the costs of regulation, which must be set against the cost of
using the market.
Table 4.19: Direct and indirect costs of regulation
Direct costs
• Supervisory structure expenses (e.g. the cost of
running the SA Financial Services Board) – “lead
regulator” arrangements can overcome duplication
and double reporting to a limited extent only
• Rulebook expenses
• Computer system expenses
• Human resource expenses (particularly compliance
office staff)
• Contributions to compensation schemes (particularly
the fund management portion)
• Legal fees
70
Despite its high costs, it may even yield a poor return
or impair the efficiency of the financial system.
Curtailing regulatory costs is therefore of great
importance in preserving a country’s international
competitiveness. Some of the more important cost-
reduction techniques are encompassed by the
following regulatory arrangements:
• Capital-adequacy standards, which in effect
delegate a greater part of the risk exposure to
shareholders. Indeed, capital ratios, once they are
high enough, imply that a financial institution can
virtually take any risk it likes.
• Adequate disclosure and standards of advice,
which delegate part of the investment
responsibilities specifically to the investor.
• Automated trading systems, which ensure the “best
price” for investors at low costs.
• Efficiency statement, which requires regulatory
authorities to make a statement about the cost-
effectiveness of their measures.
• Compensation schemes, as potential claims are
often lower than supervisory costs (provided that
the premiums of the schemes are actuarially
determined to avoid moral hazards).
• Professional indemnity insurance, but not to the
extent that insurers de facto determine what is fit
and proper for investment business.
Indirect costs
• Reduces competition (particularly by regulatory
capture)
• Stifles innovation, as “best practice” in terms of
rulebooks will be amended only after a delay
• Loss of business to less regulated countries
• Opportunity costs of enforcing fit and proper
standards
• Regulatory burden on consumers (e.g. price of
products)
• May reduce consumer choice
• Interest of regulator served at expense of industry
and consumer
• Risk-averse regulators
Financial Regulation in South Africa: Chapter 4
• Code of business conduct, which in turn allows for
less costly rulebooks.
• One self-regulatory authority for all retail
investment business (i.e. banking, insurance and
fund management) that improves fragmented rule-
making and weak regulatory standards.
Although cost-benefit analysis of specific regulatory
measures may not always be practical or may be very
difficult at times, ultimately the onus is on the
authorities to show that their regulation will improve
social welfare.
Regulatory co-ordination and harmonisation
between domestic and foreign regulatory
agencies
To reduce systemic risks31 and ensure a level playing
field among financial institutions, the harmonisation of
international regulatory arrangements has been
assigned a high priority.
The likely degree of regulatory harmonisation
between countries depends on the degree of interaction
and integration among these countries. For instance,
immobile transactions are usually left to the local
31
Systemic risks are raised internationally as a result of increased
cross-border flows and large-scale securities trading in a variety
of financial centres, as well as advances in technology.
Table 4.20: Impact of harmonising regulatory arrangements
Favourable
• Ensures an internationally accepted minimum
standard in local markets and thus avoids
competition in laxity, which in turn would result in a
lowering of standards in regulatory regimes
• Enhances competition and efficiency by creating a
level playing field between major players in different
countries
• Avoids complicated bilateral rules and promotes
international co-operation in a world increasingly
characterised by globalisation (e.g. regulatory
authorities can share in the experiences of
counterparties abroad)
• Reduces the authorities’ exposure to lobby-group
pressure
• Lowers the country’s sovereign risk and thus its
credit costs
Financial Regulation in South Africa: Chapter 4
regulators, as is mostly the case with retail trade.
Those regulations that address major cross-border
flows or systemic risks can be harmonised between
countries either by negotiation and/or regulatory
competition. Negotiations have the disadvantage that
they may involve lengthy discussions in which the
vested interests of lobby groups have to be bridged.
Regulatory competition may work more quickly but
may result in a lowering of standards.
In order to avoid “competition in laxity” between
regulatory regimes it is of great importance to set
minimum international standards, leaving sufficient
room for countries to fine-tune the arrangement by
imposing tougher criteria.
Generally the issue of regulatory co-ordination
entails two major issues: (i) cross-market regulation
(for instance between spot and derivative exchanges);
and (ii) regulation between banking and non-banking
financial institutions.
(i) Regulatory co-ordination between markets
To implement emergency measures during periods of
financial crises (e.g. the global stock markets crash in
October 1987) and to avoid gaps in the regulatory
structure, it is crucial that regulation should be
properly co-ordinated between the various regulatory
Unfavourable
• International standards may not be suitable for the
local financial system, as fundamentally different
systems cannot converge (e.g. with regard to
ownership arrangements)
• Reduces regulatory competition and results in
reduced consumer choice (e.g. between regulated
and offshore markets)
• International standards are difficult to amend owing
to the complexities of multinational arrangements
71
authorities, both locally and abroad. For instance, the
rulebooks of the exchanges should be carefully co-
ordinated to avoid situations where, for example, the
spot market closes down, while the futures market
continues to trade.
To respond effectively and on a co-ordinated basis
to market disorder, the following recommendations
have been made by the Brady Commission (Executive
Summary, 1988, p. vii):
• One agency should co-ordinate the few, but
critical, regulatory issues that have an impact
across the related market segments and throughout
the financial system. This agency should have
expertise in the interaction between markets, and
not simply experience in regulating specific market
segments. Moreover, it should have a broad
perspective on the workings of the financial system
as a whole, both domestic and foreign, as well as
being independent and responsive.
• Clearing systems should be unified across
marketplaces to reduce financial risk.
• Margins should be made consistent across market-
places to control speculation and financial
leverage.
• Circuit-breaker mechanisms (such as price limits
and co-ordinated trading halts) should be formulated
and implemented to protect the market system.
• Information systems should be established to monitor
transactions and conditions in related markets.
Since the Brady Commission Report, considerable
discussion has taken place worldwide on the merits (and
drawbacks) of a single regulatory authority. Detailed
investigations were launched by the major exchanges,
but the regulatory structure based on the multi-functional
Table 4.21: Impact of a single regulatory authority for markets
Favourable
• Addresses cross-market risk explicitly and thus
reduces systemic risk
• Links spot and derivative instruments in the four
basic markets more closely together
• Facilitates netting between spot and derivative
instruments (e.g. novation)
72
approach has remained more or less intact. Research
seems to indicate that the fundamental causes of the
1987 crash were largely related to market congestion and
information lags. The fact that the regulatory structure
was of a multi-functional nature aggravated the problem,
particularly when the spot and derivative markets moved
increasingly apart during the crash.
The key advantage of a single regulatory authority is
that it explicitly addresses cross-market risks, as the
spot and derivative transactions are concluded on the
same exchange.32 The major disadvantage of a single
regulatory authority is the temptation to over-regulate,
as competition between spot and derivative markets
may be reduced. In addition, regulatory co-ordination
between markets has become complicated owing to the
unbundling of traditional exchange activities,
particularly since the late 1980s.
Ultimately, it is of secondary importance by whom,
how and where a trading service is delivered. By
contrast, it is of the utmost importance for exchanges
to promote market transparency and a central
marketplace. Improved technology and the freedom of
international capital flows have resulted in keen
competition between the traditional stock exchanges
and the new derivative exchanges, OTC markets and
foreign securities markets. International competition
has already pulled the primary and secondary markets
apart, and as a result exchanges are rapidly losing their
most profitable activities to competitors (“cherry
picking”). This is partly because competition is
eroding the potential to “cross-subsidise”.
32
In terms of this regulatory structure, financial hybrids (such as
the ELFI bond) will be traded on the same exchange as the
underlying instrument
Unfavourable
• May result in regulatory capture and less
competition
• May result in over-regulation
• Bureaucratic
• Unwieldy
Financial Regulation in South Africa: Chapter 4
 Although the increased competition eliminates
economic rents (as reflected in high costs and/or high
profits), it may also result in increased systemic risks.
In this competitive environment the regulatory
authorities have to ensure primarily that no competition
will take place in regulatory laxity (e.g. by stipulating
similar surveillance and listing requirements), and that
securities firms meet appropriate capital, liquidity,
system and other prudential requirements. In fact,
promoting competition and full disclosure may even
bring about less need for regulation.
Table 4.22: Impact of a single regulatory authority for banking and
non-bank financial institutions
Favourable
• Combines institutional and functional approaches to
regulation
• Enhances the supervision of complex groups
• Reduces the problem of a multiplicity of regulatory
authorities
• Enhances competitive neutrality between the
suppliers of financial services
• Enhances economies of scale in the use of
resources in regulation
• Reduces potential conflicts over jurisdiction and
authority when the authorities have to adapt to
changing market conditions
• Creates greater transparency for the public and may
add to the credibility of the supervisory and
regulatory process
• Consistent approach to rule-based supervision
• Accountability easier
• Lower cost for firms
• Consistent authorisation procedures
• Consistent enforcement and discipline
Financial Regulation in South Africa: Chapter 4
(ii) Regulatory co-ordination between banking
and non-banking financial institutions
A single regulatory authority to supervise and regulate
banks and non-banking financial institutions has some
major advantages, although the problems of such a
structure should not be underestimated either (see Table
4.22). Like the issue of ownership, this issue is greatly
influenced by the regulatory philosophy of a country.
Unfavourable
• May result in a bureaucratic and unwieldy regulatory
organisation
• May increase the concentration of power and
complicate issues related to accountability
• May create problems associated with uniformity and
a monopoly of wisdom
• Reduces competition between regulatory authorities
and thus may adversely impact on the balance
between regulation and competition in financial
services
• Conflicts of culture internally
73
 Box 4.1: List of core principles for effective banking supervision
1. An effective system of banking supervision will have clear responsibilities and objectives for each agency
involved in the supervision of banking organisations. Each such agency should have operational
independence and adequate resources. A suitable legal framework for banking supervision is also
necessary, including provisions relating to the authorisation of banking organisations and their ongoing
supervision; powers to address compliance with laws as well as safety and soundness concerns; and legal
protection for supervisors. Arrangements should be in place for sharing information between supervisors and
protecting the confidentiality of such information.
Licensing and structure
2. The permissible activities of institutions that are licensed as banks and subject to supervision must be clearly
defined, and the use of the word "bank" in names should be controlled as far as possible.
3. The licensing authority must have the right to set criteria and reject applications for establishments that do
not meet the standards set. The licensing process, at a minimum, should consist of an assessment of the
banking organisation’s ownership structure, directors and senior management, its operating plan and internal
controls, and its projected financial condition, including its capital base; where the proposed owner or parent
organisation is a foreign bank, the prior consent of its home country supervisor should be obtained.
4. Banking supervisors must have the authority to review and reject any proposals to transfer significant
ownership or controlling interests in existing banks to other parties.
5. Banking supervisors must have the authority to establish criteria for reviewing major acquisitions or
investments by a bank and ensuring that corporate affiliations or structures do not expose the bank to undue
risks or hinder effective supervision.
Prudential regulations and requirements
6. Banking supervisors must set prudent and appropriate minimum capital-adequacy requirements for all
banks. Such requirements should reflect the risks that the banks undertake, and must define the
components of capital, bearing in mind their ability to absorb losses. At least for internationally active banks,
these requirements must not be less than those established in the Basel Capital Accord and its
amendments.
7. An essential part of any supervisory system is the evaluation of a bank’s policies, practices and procedures
related to the granting of loans and making of investments and the ongoing management of the loan and
investment portfolios.
8. Banking supervisors must be satisfied that banks establish and adhere to adequate policies, practices and
procedures for evaluating the quality of assets and the adequacy of loan loss provisions and loan loss
reserves.
9. Banking supervisors must be satisfied that banks have management information systems that enable
management to identify concentrations in the portfolio and supervisors must set prudential limits to restrict
bank exposures to single borrowers or groups of related borrowers.
10. In order to prevent abuses arising from connected lending, banking supervisors must have in place
requirements that banks shall lend to related companies and individuals on an arm’s-length basis, that such
extensions of credit are effectively monitored, and that other appropriate steps are taken to control or
mitigate the risks.
11. Banking supervisors must be satisfied that banks have adequate policies and procedures for identifying,
monitoring and controlling country risk and transfer risk in their international lending and investment
activities, and for maintaining appropriate reserves against such risks.

74 Financial Regulation in South Africa: Chapter 4

 12. Banking supervisors must be satisfied that banks have in place systems that accurately measure, monitor
and adequately control market risks; supervisors should have powers to impose specific limits and/or a
specific capital charge on market-risk exposures, if warranted.
13. Banking supervisors must be satisfied that banks have in place a comprehensive risk-management process
(including appropriate board and senior management oversight) to identify, measure, monitor and control all
other material risks and, where appropriate, to hold capital against these risks.
14. Banking supervisors must determine that banks have in place internal controls that are adequate for the
nature and scale of their business. These should include clear arrangements for delegating authority and
responsibility; separation of the functions that involve committing the bank, paying away its funds and
accounting for its assets and liabilities; reconciliation of these processes; safeguarding its assets; and
appropriate independent internal or external audit and compliance functions to test adherence to these
controls as well as applicable laws and regulations.
15. Banking supervisors must determine that banks have adequate policies, practices and procedures in place,
including strict "know-your-customer" rules, that promote high ethical and professional standards in the
financial sector and prevent the bank being used, intentionally or unintentionally, by criminal elements.
Methods of ongoing banking supervision
16. An effective banking supervisory system should consist of some form of both on-site and off-site supervision.
17. Banking supervisors must have regular contact with bank management and a thorough understanding of the
institution’s operations.
18. Banking supervisors must have a means of collecting, reviewing and analysing prudential reports and
statistical returns from banks on a solo and consolidated basis.
19. Banking supervisors must have a means of independent validation of supervisory information either through
on-site examinations or the use of external auditors.
20. An essential element of banking supervision is the ability of the supervisors to supervise the banking group
on a consolidated basis.
Information requirements
21. Banking supervisors must be satisfied that each bank maintains adequate records drawn up in accordance
with consistent accounting policies and practices that enable the supervisor to obtain a true and fair view of
the financial condition of the bank and the profitability of its business, and that the bank publishes on a
regular basis financial statements that fairly reflect its condition.
Formal powers of supervisors
22. Banking supervisors must have at their disposal adequate supervisory measures to bring about timely
corrective action when banks fail to meet prudential requirements (such as minimum capital-adequacy
ratios), when there are regulatory violations, or where depositors are threatened in any other way. In extreme
circumstances, this should include the ability to revoke the banking licence or recommend its revocation.
Cross-border banking
23. Banking supervisors must practise global consolidated supervision over their internationally-active banking
organisations, adequately monitoring and applying appropriate prudential norms to all aspects of the
business conducted by these banking organisations worldwide, primarily at their foreign branches, joint
ventures and subsidiaries.
24. A key component of consolidated supervision is establishing contact and exchanging information with the
various other supervisors involved, primarily host country supervisory authorities.
25. Banking supervisors must require the local operations of foreign banks to be conducted to the same high
standards as are required of domestic institutions and must have powers to share information needed by the
home country supervisors of those banks for the purpose of carrying out consolidated supervision.

Financial Regulation in South Africa: Chapter 4 75

4. Deregulation and reregulation
As a general principle of financial regulation, regulatory
structures have to be adaptable. Without flexibility it is
difficult to address challenges such as ongoing
technological improvements, financial innovation,
increased global competition and other evolutionary
forces present in the economy. Typically, periods of
increased formal regulation are followed by periods of
deregulation and vice versa. In practice, pure
deregulation is quite rare, as the giving of more powers
to self-regulatory authorities for instance, usually goes
hand in hand with greater reliance on other regulatory
instruments such as market forces.33
As the financial system becomes more complex and
sophisticated, it also becomes more difficult to regulate
in terms of statutory rules and regulations. As a
consequence, there is a process of deregulation as well
as reregulation. Usually, less emphasis is now placed
on official constraints, but in its place more market
monitoring and discipline are introduced to ensure that
the ultimate objectives of regulation are met.
Table 4.23 gives an overview of what the process of
deregulation – which started in the early 1980s – has
meant in practice. In the area of official rules and
regulation there has generally been a significant
reduction in the number of constraints placed on
ownership, functional activity, jurisdiction and pricing.
As a result, price competition has increased sharply
hand in hand with the emergence of global financial
conglomerates. These conglomerates are typically
involved in all the major financial functions,
operating in all the major jurisdictions with strongly
interrelated ownership structures. However, to make
this deregulation process possible – i.e. without
endangering the objectives of regulation – greater
emphasis had to be placed on minimum standards (e.g.
accounting standards) and initially, at least, more
operational constraints, particularly in the fields of
prudential requirements, code of conduct requirements
and anti-cartel arrangements. But even in these areas
33
Entailing in turn reregulation in areas such as disclosure
requirements, transparency rules, minimum standards of advice,
or conflicts-of-interest avoidance arrangements.
76
of operational constraints the tide has been changing
since the mid 1990s in favour of more market-related
instruments such as specific incentive contracts and
private sector structures to support prudential risk
exposures (e.g. value-of-risk modelling) and codes of
business conduct (e.g. as reflected in the corporate
governance structures).
As is evident in Table 4.23 the deregulation of some
key statutory rules and regulations (indicated by a “–”
symbol) implied major reregulation in areas such as
supervision, incentive structures, reliance on market
discipline, early structured intervention regimes and
corporate governance (indicated by a “+” symbol).
The employment of this large array of regulatory
instruments was required not only to compensate for
lesser official constraints, but also to offset any
possible negative impact of the new, more market-
related instruments.
Today, the regulatory regime in industrial countries
is more flexible to allow adjustment to unexpected
changes. It is also more market related than, say, two
decades ago. At the same time the regulatory regime
has become far more complex and integrated. For
instance, where risk control and compliance functions
were rather elementary in the 1970s, these functions
are today major departments in any large financial
institution, involving not only senior management, but
increasingly the board of directors as well.
In contrast to the imposition of rules and regulations
(discussed in full in Section 3.1), regulatory
arrangements do not necessarily imply restrictions on
the activities of market participants. Regulatory
arrangements aim at improving the regulatory structure
by inter alia deregulating financial markets, resorting
to more self-regulation, harmonising regulation with
that in other countries, limiting the number of
regulatory agencies, or co-ordinating the roles of
various regulatory agencies, and utilising private-
sector parties (such as external auditors and rating
agencies) in supervising capacities. A few of these
aspects will be discussed briefly below.
Financial Regulation in South Africa: Chapter 4
 Table 4.23: Regulatory matrix: The impact of deregulation in the context of the total regulatory regime
Institutional safety and
Regulatory ultimate objectives Systemic stability Consumer protection
soundness

Regulatory
intermediate goals

liquidity
fairness
schemes

neutrality
disclosure

Proper risk
retail funds

assessment
Competitive
Integrity and
Competence
Protection of

infrastructure
infrastructure
Fit and proper
Access to retail

Financial Regulation in South Africa: Chapter 4

competitiveness
competitiveness

Sufficient market
financial services

market exposures
Acceptable cross-
Transparency and

directors and staff

Global institutional

Proper institutional

Competitive market
Retail compensation

currency mismatches
Securities markets as
Regulatory regime and

efficiency and economy

Acceptable maturity and

Regulatory effectiveness,
Adequate product/service

its instruments

alternative to intermediation
1. Official rules and regulations
1.1 Entry and standards constraints + – + + + + + + + +

1.2 Ownership constraints –

1.3 Functional activity constraints – – –

1.4 Jurisdictional constraints – – –

1.5 Pricing constraints –

1.6 Operational constraints + + + + + + + + + + – –

2 Official monitoring and supervision + + + + + + + + + +

3. Intervention and sanctions + + + + + + +

4. Incentive contracts and structures

5. Market monitoring and discipline + + + + + + + + + + + + + + + +

6. Corporate governance + + + + + + + + +

7. Discipline/accountability of
+ + +
regulators

77
4.1 Deregulation
Deregulation has created an environment of greater
freedom. Firstly, controls on prices, quantities and
cross-border capital movements have been lessened or
even removed in full. Secondly, as a result of
institutional despecialisation and the opening of
domestic markets to foreign competition, financial
enterprises have been given much greater freedom to
choose lines of business, location, area of operation
and financial structures.
Deregulation intensifies the competitive
environment, particularly in the early stages of major
adjustments to portfolio composition. It may lead to a
redistribution of income from the suppliers to the users
of financial services and thus increase the fragility of
the financial system. Moreover, the oligopolistic
structure of the financial industry frequently
pressurises firms into moving together (the “herd
Table 4.24: Impact of financial innovation
Favourable
• Increases the variety of financial instruments
available to both borrowers and lenders by
combining different standard characteristics in
different instruments ("spectrum filling")
• Improves the liquidity of the system to the extent that
tradable assets and markets are created
(securitisation) – innovation thus enhances portfolio
management
• Encourages competition between banks (asset-
liability transformation) and securities firms
(securitisation)
• Facilitates the pricing and transferring of particular
risks (unbundling)
• May give borrowers access to markets from which
they had previously been excluded
• Lowers the cost of finance or the transactions costs
involved in accomplishing what is already possible
• Allows participants to attain previously impossible
goals, and provides new sources of finance to some
borrowers
• Accelerates international financial integration,
resulting in more competitively neutral legislation
• Allows some risks to be managed and shifted
78
instinct”), which in turn results in “overshooting” a
longer-run equilibrium position.
Deregulation is necessary to create scope for
financial innovation (see Table 4.24) and to
accommodate the increasing pressures emanating from
globalisation. Today the deregulation of financial
markets seems unavoidable, although it should be
handled with care. Cognisance should be taken of the
important policy lessons learned over the past few
years in respect of the deregulation process:
• Deregulation should proceed rapidly but at a pace
that gives market participants sufficient time to
prepare themselves for the new environment in
terms of internal controls, restructuring and
adjustments to their business strategies, training of
staff and so on.
• A proper balance should be struck between
deregulation in different segments of f i n a n c i a l
Unfavourable
• Puts a premium on the efficiency and soundness of
clearing and settlement arrangements (in view of the
spectacular surge in financial transactions and its
impact on the payment system)
• Complicates the evaluation of financial institutions'
risk exposures, which in turn may lead to over-
regulation
• May result in shareholders obtaining insufficient
financial information, particularly about off-balance-
sheet risk exposures
• Results in specific financial instruments being
created primarily to evade the regulatory control
system (e.g. "daylight" funds)
• Securitisation results in an increased opaqueness of
the financial system where an off-balance-sheet
commitment may become an on-balance-sheet item,
and vice versa
• Complicates macroeconomic management owing to
large-scale disintermediation and re-intermediation
• Risks may not be fully understood in complex
instruments
Financial Regulation in South Africa: Chapter 4
 markets to ensure that competition among them is
not grossly distorted.
• The right time for deregulation may be best
defined in terms of the wrong time, which is when
the economy is in or moving into a powerful boom.
• Deregulation should be accompanied by a
strengthening of supervision so as to establish rules
of the game (the Basel capital-adequacy standards
are a good example) and by appropriate macro-
economic policy, especially monetary policy.
• Transparency and disclosure should accompany the
deregulation process.
• Banks should develop adequate risk analysis,
management and control systems.
• Effective and transparent corporate governance
arrangements should be created within banks.
Table 4.25: Impact of deregulation of financial markets
Favourable
• Creates an environment of greater freedom and
enhances more active competition and a more level
playing field between financial institutions
• Encourages competitively neutral legislation,
particularly between financial and non-financial
institutions (allows for more diversification)
• Allows companies to arbitrage between less efficient
and more efficient national financial systems
(globalisation)
• Allows for more self-regulation – at least if all
participants are adequately capitalised and subject
to appropriate disclosure standards
• Reduces over-regulation that often imposes a
“tax” on financial institutions and thus raises the
supply price of services, which in turn impairs
competitiveness
• Lowers regulatory costs (as competition takes the
place of rules)
• Allows for the creation of new regulatory structures
enforced by competitive forces
• Exposes unsound risk arrangements (e.g. the
stipulation of unlimited liability for exchange
members does not enhance systemic stability, as
members may keep their wealth in private trusts)
• Improves international competition
Financial Regulation in South Africa: Chapter 4
• Market discipline arrangements should be
strengthened.
A distinction needs to be drawn between the stock-
adjustment effect of moving from one regulatory
regime to another, and the steady-state characteristics
of a deregulated environment. Substantial changes to
the regulatory regime may be very destabilising during
the period in which institutions adjust to the new
regime. New behavioural characteristics may need to
be learned and institutions have the problem of
handling increased uncertainty when new regulatory
regimes and market conditions are created. Mistakes
may be made in this stock-adjustment phase. However,
this does not mean that the resultant instability is a
characteristic of the new deregulated steady-state
condition. The conditions created, when moving from
Unfavourable
• Necessitates more institutional and functional
regulation to mitigate the impact of deregulation
• Necessitates that the nature and form of local
regulation are not out of step with the international
regulatory regime (as the same client can be
serviced from different countries or different
markets)
• Results in greater competition and lower profitability
and thus encourages diversification into new
businesses with potentially increased systemic risks
• Increases entry costs (e.g. if fixed commissions fall
away, this will ultimately harm small undercapitalised
firms) and may result in higher costs for retail
investments (as internal cross-subsidising will be
eliminated)
• May result in portfolio adjustments that are swift,
substantial, potentially unstable and difficult to
moderate
• The overall risk characteristics of the industry may
increase owing to greater competition
79
one regime to another, indicate nothing about the new
steady-state regime when all transitory adjustments
have been made.
4.2 Reregulation and self-regulation
Self-regulation entails two elements: the primary
policy makers within the recognised self-regulatory
organisation (SRO) are themselves practitioners, and
the organisation is funded by the market rather than
with public funds.
In most countries there are significant elements of
self-regulation in finance. The main issues relate to the
effectiveness, durability, acceptability and credibility
of self-regulation as a principle. Self-regulation
through recognised bodies has much to commend it,
especially if there are built-in safeguards to protect
against the obvious potential for an abuse of authority
(see Table 4.26).
However, there is the obvious danger of the
regulators being “captured” by the industry – in fact by
themselves, for they are the industry! Self-regulation
rests substantially on the acceptance of the regulated
Table 4.26: Impact of self-regulatory organisations (SROs) on regulation
Favourable
• Regulation is carried out by acknowledged experts
in the market
• The regulators' standing in the market is likely to
enhance the consent and compliance of the
regulated
• The SRO is fully aware of innovations and their
implications and can adapt accordingly
• The SRO is likely to be less legalistic and dogmatic
in its decisions
• It is in the self-interest of the SRO to maintain
standards and retain the public's confidence in the
market
• The SRO is better positioned to detect abuses of the
regulatory system (e.g. free-riders)
• The SRO can operate with greater flexibility, speed
and effectiveness than direct regulation
80
and, unless there are powerful sanctions, this may not
always be guaranteed. There is the question whether it
is possible to rely on self-regulatory bodies always
serving the public interest as the public defines this
(rather than the industry). The issue centres on the
optimum combination of self-regulation and externally
imposed regulatory requirements.
Though there must be a powerful element of self-
regulation, there should also be checks and balances
built in so as to maximise the benefits of self-
regulation while limiting its potential hazards. The
distinction between self-regulation and statutory
regulation is to some extent artificial: the debate is
ultimately about the balance to be achieved between
the industry, the state and consumers in the
implementation of the law. It is necessary to have
safeguards against the potential hazards of exclusive
self-regulation, while securing the maximum benefits
of practitioner input into the regulatory process. It
forms the regulatory process through experience and
specific expertise of the industry and its practices.
Generally self-regulation is more appropriate for
Unfavourable
• Regulatory capture by the SRO becomes a major
threat
• The creditability of the SRO may be questioned by
the public
• Regulation may be used to protect the industry
rather than clients in the case of difficulties ("fair
weather" regulation)
• Regulation may degenerate into an anti-competitive
device designed to protect a cartel – accordingly
competition may be stifled
• The industry's view of public interest may dominate,
to the detriment of the client (i.e. who defines the
public interest?)
• The SRO may operate as a self-maintained
organisation, which does not smoothly co-operate
with other regulatory agencies
• The SRO may not have sufficient sanctioning and
investigative powers to enforce flexible self-
regulation (e.g. to subpoena witnesses)
Financial Regulation in South Africa: Chapter 4
wholesale investment business than retail business34.
It is interesting, for instance, that the principle of
self-regulation does not apply to banking. In
practice, the issue relates to the optimum
combination of self-regulation and externally
imposed regulatory requirements.
5. Summary
Evaluating the scope of regulatory instruments makes
it evident that some regulatory instruments are more
favourable than others. In a world dominated by free
capital flows, globalisation and sharply increased
competition, there is little scope for restrictions on
ownership, jurisdiction, pricing and trading capacity.
For similar reasons, the following regulatory
instruments have gained in importance during the last
few decades: stipulating minimum entry requirements
and standards; capital and liquidity constraints;
corporate governance rules, adequate disclosure and
standards of advice requirements; and an enforceable
code of business conduct.
In respect of regulatory arrangements the regulatory
structure in many countries has been strengthened by the
deregulation of financial markets (usually going hand in
hand with stricter regulation of market participants and
financial instruments), more self-regulation for
wholesale investment business, international regulatory
harmonisation and better co-ordination between
regulatory authorities and private sector supervisors
(such as external auditors and rating agencies).
Regulatory instruments that are somewhat
contentious today are restrictions on functional activity
and the whole issue of how to ensure competitive
neutrality, particularly between financial and non-
financial institutions.
The most important world trends in regulation may
be summarised as follows:
Ethos of regulation
• Increased emphasis on enhancing competition in
finance;
• enhanced role for market mechanisms;
34
Typically SROs at the retail business level are as much involved
in supervision as regulation.
Financial Regulation in South Africa: Chapter 4
• increased priority given to efficiency in finance;
• competitive neutrality between competing
subsectors of the financial system.
Deregulation
• Wider business opportunities to institutions;
• greater price flexibility (e.g. interest rates);
• self-imposed restrictive practices competed away
and removed by regulatory changes;
• less direct control over prices and allowable
business;
• less direct credit control mechanisms.
Structure of regulation
• A tendency towards integrated supervisory
agencies;
• wider range of financial services subject to
regulation;
• international co-ordination mechanisms.
Methods of regulation
• Regulation has become more interventionist and
detailed, with regulatory authorities developing
comprehensive rulebooks governing the way
financial services are supplied;
• more formal and explicit “business conduct” rules
in the context of distinctions between types of
financial institutions being eroded;
• regulation and supervision are increasingly based
on functional rather than institutional criteria (e.g.
the consolidation requirements for banks and
securities business);
• greater emphasis on capital requirements – rules on
the allowable definitions of capital structure and
capital adequacy;
• information and disclosure requirements extended.
While there is an overwhelming case for regulation
in financial services, there are certain danger factors:
the benefits of regulation should not be exaggerated;
false expectations in consumers’ minds should not be
encouraged; and the potential moral hazard of implicit
contracts should be guarded against. It is necessary
that expectations should be not raised to unrealistic
levels, that it be clear that regulation has only a
limited role, that regulation and supervision can fail,
and that under no circumstances should regulatory
81
arrangements be created that reduce the incentive for adequate information and the intelligent use of what
users of financial services to exercise due care. In the information is available. Not all risks are covered, and
final analysis, regulation is never an alternative to neither could, or should they be.

82 Financial Regulation in South Africa: Chapter 4

 Chapter 5
REGULATORY RESPONSES TO GLOBAL FINANCIAL DISTRESS
1. Introduction
The realignment of policy instruments to ensure their
optimum economic effectiveness and cost-efficiency is
increasingly becoming an international process. For
example, the global policy responses to financial crises
over the past few decades have become more uniform
as regulators started to learn from past mistakes and
even begun to harmonise their regulatory structures
with international “best standards”. As a result the
national regulatory structure is becoming increasingly
a reflection of global standards with relatively minor
country-specific differences.
As discussed in Chapter 3, the concept of a
regulatory regime is considerably wider than the
prevailing set of prudential and conduct of business
rules established by external regulatory agencies. It is
widened to include the nature of the incentive
structures operating within financial institutions, the
role of monitoring and supervision (by private and
official agencies), the disclosure regime and the role of
market discipline, and corporate governance
arrangements. It also includes the arrangements for
official intervention in the event of distress in the
financial system. Just as the causes of financial crises
are multidimensional, so the principles of an effective
regulatory regime must also incorporate a wider range
of issues than just externally imposed rules on the
behaviour of financial institutions.
A central theme is that, while external regulation has
a role in fostering a safe and sound financial system,
this role is limited. Equally and increasingly important
are the incentive structures faced by private financial
institutions, particularly banks, and the efficiency of
the necessary monitoring and supervision of financial
institutions by official agencies and the market.
External regulation is only one component of regimes
to create a safe and sound financial system.
Financial Regulation in South Africa: Chapter 5
In this chapter, Section 2 sketches the underlying
causes of recent financial crises, as a background for
Section 3, which in turn looks at the global policy
responses to those financial crises. Although
financial crises are still not fully understood (and
therefore appear unexpectedly), the major lessons
learnt from past experience seem to indicate that the
structure of financial regulation can be improved in a
number of ways. Firstly, by stipulating minimum
infrastructure requirements for institutions as well as
markets (e.g. accounting, audit, capital adequacy,
corporate governance). Secondly, by setting in place
specific supervisory structures to monitor complex
financial groups in their totality. Thirdly, by
enhancing the securities markets as a stable source of
finance and an alternative to financial intermediation.
Fourthly, by avoiding the build-up of major asset price
imbalances (particularly currency, equity and real-
estate prices that no longer represent “fundamental”
value). And lastly, by creating new regulatory
arrangements in respect of safety nets and by making
the regulators themselves more accountable for their
actions (or lack thereof, e.g. in respect of forbearance).
2. Underlying causes of
financial crises
From a regulatory viewpoint, financial crises fall
(roughly) into two major classes: (i) those that have
primarily a macroeconomic character and for which
monetary, financial and fiscal policies seem the
appropriate economic instruments; and (ii) those that
have a more explicit financial regulatory component. It
has to be emphasised immediately, however, that there
is a strong interrelationship between financial
instability and macroeconomic instability. Accordingly
it may be difficult in practice always to distinguish
clearly between these two classes.
A recent IMF study of banking crises around the
83
world begins as follows: “A review of the experiences
since 1980 of the 181 current Fund member countries
reveals that 133 have experienced significant banking-
sector problems at some stage during the past fifteen
years (1980–1995)”1 (Lindgren, 1996). Crises in the
banking sector (in both developing and industrial
countries) are clearly not random, isolated events.
Around the world, banks in many countries have had
very high levels of nonperforming loans, there has been
a major destruction of bank capital, banks have failed
and massive support operations have been necessary.
This represents a greater failure rate among banks than
at any time since the great depression of the 1930s.
They have involved substantial costs. In around 25
percent of cases the cost has exceeded 10 percent of
gross national product (for example, in Spain,
Venezuela, Bulgaria, Mexico, Argentina and Hungary).
The main causes of recent crises have been those
that have always attended commercial banking
problems: poor risk analysis by banks, weak internal
credit-control systems, connected lending, insufficient
capital, ineffective regulation, weak monitoring and
supervision by regulatory agencies, and weak internal
governance. These factors have frequently been
aggravated by a volatile conduct of economic policy
and structural weaknesses in the macroeconomy. In
other words, the origins of crises are both internal to
banks and external. To focus myopically on one side
misses the essential point that systemic crises have
both macro and micro origins.
Almost always and everywhere banking crises are a
complex interactive mix of economic, financial, and
structural weaknesses. While each banking crises has
unique and country-specific features, they also have a
lot in common. Several conditions tend to precede
most systemic banking crises:
• Rapid growth in bank lending within a relatively
short period.
• Unrealistic expectations and euphoria about
economic prospects in the economy.
1
Lingren, G.J., G. Garcia, and N. Saal, Banks Soundness and
Macroeconomic Policy, Washington, DC: IMF, 1996.
84
• A sharp and unsustainable rise in asset prices (part
of euphoria speculation), leading to unrealistic
demands for credit and willingness of banks and
other lenders to supply loans.
• Concentrated bank portfolios often with a high
property content (that is, while project risks may be
properly assessed, portfolio risk is often not).
• Excessive interconnected lending within banking
groups.
• Government involvement in loans and loan
decisions, which may have the effect of weakening
incentive structures, eroding discipline on lenders
(an implicit guarantor), and involving undue
political influence or insider relationships.
• Inappropriate risk premia being charged in lending
interest rates.
• Insufficient attention being given to the value of
collateral, most especially if rapid balance-sheet
growth occurs in a period of asset-price inflation.
• Weak conduct of monetary policy in a context of a
high and volatile rate of inflation.
2.1 Macroeconomic causes of
financial crises
Macroeconomic changes are more quickly reflected in
markets than in institutions. However, all changes in
macroeconomic policy impact directly on the balance
sheet of the banking industry, and therefore
macroeconomic instability is quickly transformed into
financial instability.
An important reason that it may be useful to
distinguish between the macroeconomic causes of a
financial crisis versus failures in the regulatory regime
itself, is that the financial regulatory authorities
usually have little direct influence on macroeconomic
policy. For instance, even though there is usually a
close interaction between the banking supervisors and
the central bank, bank supervisors have no say in
monetary policy. From the financial regulators’ point
of view, financial crises caused by macroeconomic
mismanagement are more or less a given. Accordingly,
financial institutions need sufficient capital and other
types of reserves to withstand such exogenous
Financial Regulation in South Africa: Chapter 5
headwinds. Alternatively, should the financial crisis be
particularly severe, macroeconomic support may have
to be provided in the form of, for instance, lower real
interest rates (i.e. additional liquidity) by the central
bank. To what extent the policy makers should use
their discretion in such situations is still a highly
debatable issue among central bankers.
Judging by economic developments over the past
few decades, it seems that the following
macroeconomic factors have contributed in a major
way to financial distress:
• Macroeconomic volatility: This can derive from
several sources – both external and domestic.
External factors include, for instance, large
fluctuations in the terms of trade, relatively low
export diversification, volatile international interest
rates (and the induced effect on private capital
flows) and real exchange-rate volatility. On the
domestic side, economic growth and inflation rates
are both often highly volatile. As a result,
economies are at times exposed to massive over-
consumption (e.g. Mexico 1995), too high levels of
domestic investments (e.g. the Asian crises of
1997), too large internal debt levels (e.g. Japan,
1990s), or unserviceable external debt levels (e.g.
Russia, 1998).
• Exchange rate regimes: Fixed exchange-rate
regimes have been criticised for increasing the
fragility of the banking system as regards external
adverse shocks, because such shocks so easily lead
to a balance-of-payment deficits, a decline in the
money supply and higher domestic interest rates. A
recent example was Argentina’s response to the
large liquidity shock to the banking system that
followed the Mexican crises in early 1995. The
central bank of Argentina had to perform a delicate
balancing act and ensure sufficient liquidity to
prevent a contagious bank crisis, but not provide so
much liquidity as would extend the exchange-rate
commitment. It has also been argued that fixed
exchange rates (governments’ alleged commitment
to an exchange-rate level) can create moral hazard
by inducing banks to fund high interest-rate loans
Financial Regulation in South Africa: Chapter 5
in domestic currency with low interest-rate foreign
currency liabilities. The unmatched foreign
currency position can cause a bank to become
insolvent in the event that the domestic currency is
devalued (e.g. Thailand).
• Lending booms, asset price collapses and surges
in capital inflows: Excessive credit extension and
unsound financing during the expansion phase of
the business cycle can cause banking crises – a
crisis is triggered when the bubble bursts. Usually
banks find it harder to discriminate between good
and bad credit when the economy is expanding
rapidly: borrowers are at least temporarily very
profitable and liquid. Moreover, sharp swings in
real-estate and equity prices intensify these crises
because of high loan concentration, whereas asset
price declines depress the market value of collateral.
Examples are the stock market crash of 1987, the
bond market collapses in 1958 and 1994, Venezuela
1994–1997, or the difficulties with highly leveraged
companies such as Long Term Capital Management
in 1998. From a monetary policy viewpoint, the big
question today is whether the monetary authorities
should recognise that “if trouble emerges, it usually
comes unexpectedly and from a clear blue sky” and
pay explicit attention to asset price developments
(particularly when associated with rapid credit
extension) or whether they should concentrate
exclusively on domestic inflation.
• Contagion across markets and countries: Even if
a specific market or country is well regulated and
financially sound, it may be adversely affected by
distress elsewhere in the region. For example many
of the “Asian tiger” countries were badly mauled
by the financial crisis of 1987 in Thailand (and
soon thereafter Malaysia and Indonesia). Usually
contagion spreads quickly through a region by
means of two channels: firstly, a general lack of
investor confidence in that specific region, with
resulting reallocation of capital to other parts of the
world; and secondly, an exchange rate fear among
these investors that countries in the region will
have to devalue their currencies in tandem simply
85
 to remain trade competitive. Different countries
may react differently to the impact of contagion.
For instance, during the Asian crisis, Taiwan
devalued its currency, despite its huge foreign
exchange reserves, to remain price competitive in
the region. In contrast Hong Kong left its exchange
rate unchanged, but then had to increase its interest
rates sharply, which in turn resulted in a major fall
in equity and property prices. In the absence of
devaluation, the result was price deflation and a
worsening of the downturn.
• Lack of market liquidity: A sudden hardening of
monetary policy may have major liquidity
consequences for markets and even countries.
Usually, a liquidity crisis is reflected in higher
domestic interest rates and a weaker currency with
major consequences for business confidence and
price stability. To a limited extent the authorities
can trade-off interest-rate hikes against exchange-
rate devaluation. Indeed, if foreign investors lose
confidence in a country they have to pass two
hurdles: they first have to change their investments
into local currency (thus trading in the equity or
bond markets), and thereafter they have to change
local cash into say dollars (i.e. trade in the foreign-
exchange markets). The quicker the authorities
raise their interest rates, the faster the fall in
domestic asset prices. If foreign investors feel they
are in a bear trap, they may not sell their assets
immediately and wait for a price recovery in the
domestic asset markets. Accordingly, major selling
pressure is taken off the forex market (at least
temporarily). Once business sentiment has changed
for the better, the authorities can increase the
liquidity in the financial system again.
2.2 Regulatory causes of financial crises
Where the macroeconomic causes of financial crises
usually affect markets, the microeconomic causes of
financial distress are virtually, as a rule, related to
institutions. However, in practice the interaction
between market and institutional failures may be so
great that it is practically impossible to distinguish
86
between them properly. Nonetheless, the following
causes of financial distress can be identified in this
area (see also Diagram 5.1 which in essence
emphasises that trouble can easily emerge from a clear
blue sky):
• Weaknesses in the accounting, disclosure and
legal framework: Many banks in emerging
markets engage in “evergreening”, i.e. making bad
loans look good by lending more money to troubled
borrowers, or by “rescheduling” arrears. If non-
performing loans are systematically understated,
loan loss provisions will be inadequate, and the
reported measures of bank net income and bank
capital will be systematically overstated (e.g. Chile
and Colombia in the early 1980s).
• Increasing bank liabilities with large maturity
and currency mismatches: A large unhedged
debtor position in foreign exchange not only makes
banks and their customers more vulnerable, but
also makes it harder to deal with a banking crisis
once it occurs (because an easier monetary policy
will be much less effective when debts are
denominated in foreign currencies). Similarly, the
risks of maturity mismatches are typically higher in
the emerging markets, because they have less
access to sources of longer term funding (on the
liability side) and receive less assistance from
securities markets for increasing liquidity and
spreading risk (on the asset side) than do banks in
the industrial world. An example in this category is
Mexico during 1989–94.
• Heavy government involvement: The loan
decisions of state-owned banks are much more
likely to be subjected to explicit or implicit
government direction than those of privately
owned banks. All too often, the creditworthiness of
borrowers does not receive sufficient weight in the
credit decision, with the result that the loans of
state banks can become a vehicle for extending
government assistance to ailing industries.
Moreover, because these banks are shielded from
competition, have their losses covered by the
government and are sometimes protected from
Financial Regulation in South Africa: Chapter 5
 closure on constitutional grounds, they tend to have
lower incentives to innovate, to promptly identify
problem loans at an early stage and to control costs.
Overstaffing and overextended branch networks are
also more prevalent. Moreover, their loan/loss
performance is usually inferior to that of their
private sector counterparts. Examples in this area
are Argentina, Brazil, China, India and Indonesia.
• Loose controls on connected lending: The risks
of “connected lending” are more common among
universal banks and are primarily due to a lack of
objectivity (sometimes even fraud) in credit
assessment and undue concentration of credit
risk. Key problems in the Spanish banking crises
of the 1980s were connected lending and slack
corporate governance.
• Inadequate preparation for financial
liberalisation: Regulatory reforms inevitably
present institutions with new risks. For example,
when interest rates are liberalised, banks may lose
the protection they previously enjoyed. Generally
the volatility in interest rates tends to rise, at least
during the transition period of financial
liberalisation. Rapid rates of credit expansion have
often, paradoxically, coincided with high real
interest rates in the wake of financial liberalisation.
Lifting restrictions on bank lending often releases
pent-up demand for credit in the liberalised sectors
(e.g. real-estate, securities activities). Lowering
reserve requirements permits banks to
accommodate increased loan demand – as does the
inflow of foreign capital, which is often attracted
by reforming economies. However, bank credit
managers reared in an earlier controlled financial
environment may not have the expertise needed to
evaluate new sources of credit and market risk.
Likewise, unless the supervision framework is
strengthened before the liberalisation of financial
markets, bank supervisors may have neither the
resources nor the training needed to do their jobs
properly. Examples of inadequate preparation for
financial liberalisation are Brazil, Chile, Indonesia,
Mexico and several Nordic countries. The situation
Financial Regulation in South Africa: Chapter 5
outlined above is exacerbated in countries which
have large disparities in the size of banks, i.e. a few
large banks and many small banks. In many
countries, and particularly at present in South
Africa, there is a view that a proliferation of small
banks represents a threat to financial stability in
that such banks are far more vulnerable to liquidity
risk than their larger competitors. While no bank
on its own is “too big to fail”2 there is a
considerable degree of interdependence, firstly via
the inter-bank market and secondly through public
perception which tends to regard the failure of one
small bank as the forerunner of the failure of other
small banks. The proponents of this view draw the
conclusion that the policy of “free entry, free exit”
on the part of the licensing authorities in the
banking industry is inappropriate and would
recommend that the authorisation of new (and
therefore probably small) banks should be severely
restricted as was the case in the past in South
Africa. Opponents of this view would argue that:
(i) the admission of new entrants is an essential
element to stimulate competition in the banking
industry; (ii) the threat of new entrants creates
competitive pressure on incumbent banks; (iii)
there are a number of examples on record of new
small banks growing into large and highly
successful competitors (e.g. Investec and Rand
Merchant Bank in South Africa); and (iv) though
smaller banks are undoubtedly more vulnerable to
liquidity risk than larger banks, this is a situation
that can be and has been successfully managed by
the regulatory authorities.
• Distorted incentives for bank owners, managers,
2
“Too big to fail” may be synonymous with “too important to
fail”. However, “fail” does not necessarily mean going out of
business, as the authorities may wish to keep a troubled bank as a
going concern, inter alia to protect depositors or maintain
confidence in the market. Note, that this does not mean that
shareholders or management will be protected, as the authorities
are likely to change the management of the bank, restructure it,
place it under curatorship (as in South Africa), or even
nationalise it. Further, the principle of “too big to fail” is refined
at times to mean that it is only the second bank in a financial
crisis that is “too big to fail”.
87
 bank depositors and supervisors: These main
actors in any financial drama have to be properly
discouraged from engaging in excessive risk
taking, and encouraged to take corrective action at
an early stage. Moreover, they each need to “have
something to lose” if they fail to act in a manner
consistent with their mandate. Bank owners should
lose enough capital to make them think twice about
engaging in high-risk activities3 and senior
managers should lose their jobs if a bank needs
fundamental restructuring. Bank depositors should
only be bailed out if they are small, unsophisticated
investors, whereas wholesale creditors should lose
in a case of bank failure. Finally, bad supervisors,
like managers, should be replaced with better ones
irrespective of the political pressures such a step
usually entails. Alternatively, their powers should
be reduced by placing more emphasis on
disclosure, market discipline and sanctions.
Last but not least, it should be emphasised that all the
financial crises discussed above have not come
cheaply. As shown in Diagram 5.2, the fiscal costs (i.e.
to the taxpayer) of a banking crisis can easily exceed
10% of gross domestic product. In the past two
decades, more than 130 countries suffered major bank
failures4, and not surprisingly the authorities worldwide
are keen to promote financial stability and to strengthen
the financial system.
3. Global regulatory responses to
financial crises
Having analysed the causes of financial crises, the
regulatory authorities’ responses have been generally
to concentrate their efforts in five areas, namely:
• Efforts to improve the infrastructure of markets and
institutions, particularly in harmonising minimum
3
Banking is an inherently risky business. Nonetheless, banks have
unusually high leverage. In non-bank firms a debt-equity ratio of
1 to 1 is considered high and a ratio of 4 to 1 reckless. But in a
bank a ratio of say 10 to 1 is considered prudent.
4
Caprio, G. and D. Klingebiel, Episodes of systemic and
borderline financial crises, World Bank, Washington, 1999 and
Leechor, C., “Banking on Governance”, Public policy for private
sector, World Bank, Washington, December 1999.
88
(international) standards and guidelines. Corporate
governance, compliance structures, proper
incentives, adequate transparency and clear
accountability are of particular importance here.
• Greater reliance on market-led processes to provide
the discipline required to encourage prudent and
stabilising behaviour. Reliance on market
processes also implies that the authorities
forcefully support the development of securities
markets as an alternative to formal financial
intermediation.
• Reinforcing market discipline with official
integrated monitoring and supervision activities,
particularly in complex financial groups.
• Promoting financial stability (in addition to
monetary stability) by “leaning against the wind”
during the financial cycles, particularly in areas
such as credit expansion and financial gearing.
• Improving regulatory arrangements and
competitive neutrality as well as avoiding
regulatory arbitrage by explicitly acknowledging
the international dimension of financial regulation.
In essence the above approach tries to counteract all
the factors causing financial distress as identified in
the previous section. In terms of the regulatory matrix
(see Table 4.23 in Chapter 4), it implies a massive
repositioning of the available policy instruments in the
regulatory regime: i.e. less emphasis on official rules
and regulation and more reliance on market forces,
which in turn entails a huge shift in the overall
regulatory architecture. This section will discuss each
of these five initiatives in greater detail.
3.1 Improvements in the financial
system’s infrastructure
The infrastructure of markets and institutions is
usually improved by: (i) harmonising domestic
regulatory standards with minimum international
standards (including capital-adequacy standards); (ii)
emphasising the importance of corporate governance
rules; and (iii) by ensuring that institutions and
markets are subjected to appropriate compliance
procedures. As the last two items are discussed in
Financial Regulation in South Africa: Chapter 5
 Diagram 5.1: Factors behind 29 bank insolvencies

MACROECONOMIC FACTORS
Capital flight 2
Dutch disease 4
Asset bubble 7
Recession 16
Terms of trade drop 20

MICROECONOMIC FACTORS
Weak judiciary 2
Fraud 6
Lending to state enterprises 6
Connected lending 9
Political interference in lending 11
Deficient bank m anagement 20
Poor supervision & regulation 26

0 5 10 15 20 25 30

1. As indicated above, bank insolvencies are at times due to bad luck (e.g. capital flight or bank runs), or bad shocks (e.g. recession or adverse
terms of trade).
2. Source: G.Caprio and D.Klingebiel "Bank Insolvency: Bad luck, Bad policy, or Bad banking" in M. Bruno and B Pleskovic (eds), Annual World
Bank Conference

Diagram 5.2: Cost of banking crises

Ghana, 1982-89
United States, 1984-91
Sweden, 1991-94
Russian Fed., 1998
Norway, 1987-93
Czech Rep., 1989-91
Brazil, 1994-96
Philippines, 1983-87
Malaysia, 1997-present
Spain, 1977-85
Mexico, 1995-present
Japan, 1990s
Venezuela, 1994-97
Cote d'Ivoire, 1988-91
Rep. of Korea, 1997-present
Thailand, 1997-present
Chile, 1981-83
China, 1990s
Indonesia, 1997-present
Argentina, 1980-82

0 5 10 15 20 25 30 35 40 45 50 55 60

Fiscal costs as a percentage of GDP

Financial Regulation in South Africa: Chapter 5 89

Chapter 4, attention will only be given in this section
to the various international minimum standards.
Today the international approach is mainly to
improve the financial system incrementally5.
Accordingly, changes to the infrastructure are brought
about in a piecemeal policy solution fashion, i.e. a
consistent “bottom up” approach.
So far the following international standards have
been worked out:
• International Accounting Standards (IAS) by
the International Accounting Standards Committee
in co-operation with Basel Committee on Banking
Supervision and IOSCO and endorsed by IOSCO
in May 2000.
• International Standards on Auditing (ISA) by
the International Federation of Accountants through
its International Auditing Practices Committee.
• Core Principles for Systemically Important
Payment Systems, by the BIS Committee on
Payment and Settlement Systems (CPSS) and
issued in December 1999.
• Core Principles for Effective Banking
Supervision by the Basel Committee on Banking
Supervision (BCBS) and endorsed by the IMF and
World Bank in October 1997.
• Objectives and Principles of Securities
Regulation by the International Organisation of
Securities Commissions (IOSCO) in September
1998. A detailed self-assessment methodology was
completed in 2000.
• Insurance Supervisory Principles by the
International Association of Insurance Supervisors
(IAIS), issued in September 1997, while its Core
Principles Methodology is expected to be
completed in 2000.
5
To impose on the world financial markets an international super-
regulator or even “A New International Financial Architecture”
is still rejected, because the causes and consequences of financial
crises are still inadequately understood; the national legislators
are not yet ready for such an enormously powerful supernational
regulatory body; the tasks of oversight and supervision are a
virtually unmanageable task for such a single agency; and the
huge shortage of skilled resources in both domestic and
international institutions.
90
• Supervision of Financial Conglomerates by the
Joint Forum on Financial Conglomerates in
collaboration with the BCBS, IOSCO and IAIS,
issued in February 1999.
• Ten Key Principles on Information Sharing by
the Group of Seven Finance Ministers in May 1998
and endorsed by the Joint Forum on Financial
Conglomerates in February 1999.
• The Forty Recommendations of the Financial
Action Task Force in respect of Financial Crime
and Money Laundering issued in April 1990 and
modified in 1996.
• Principles of Corporate Governance by the
Organisation for Economic Co-operation and
Development (OECD) and the World Bank and
endorsed by the OECD Ministerial Meeting in
May 1999.
• The Specific and General Data Dissemination
Standards (SDDS and GDDS) by the IMF and
approved by the IMF Executive Board in
respectively March 1996 and December 1997.
• Model Law on Cross-Border Insolvency by the
United Nations Commission on International Trade
Law in May 1997.
• Orderly and Effective Insolvency Procedures
issued by the IMF in 1999.
Note that nearly all these standards date from the
second half of the 1990s. The standards are de facto
enforced by means of the following (i.e. piecemeal,
bottom up) policy procedures:
• The establishment of the various core principles
and minimum standards by international technical
committees.
• Establishment of specific liaison groups to ensure
that the codes are implemented smoothly.
• Peer pressure among industrial countries (and later
developing countries) to fulfil these codes.
• Ensuring increasing regulatory co-ordination and
harmonisation through international bodies such
as the IMF, World Bank and the Financial
Stability Forum.
• Regulatory monitoring of compliance with the
codes (e.g. the IMF’s Article IV consultation).
Financial Regulation in South Africa: Chapter 5
• Penalties by private-sector institutions on those
countries deemed not to conform to the core
principles (mainly by means of higher credit
interest rates).
• Official “denying rights of establishment” in major
financial centres unless core principles are
implemented.
• Higher statutory capital requirements in the home
country for credit given to debtor countries that do
not fulfil the core principles.
Besides these core principles and minimum
standards, the Bank for International Settlements has
established three powerful Standing Committees of
national experts, namely:
• The Basel Committee on Banking Supervision
(BCBS)
• The Committee on the Global Financial System
(CGFS), and
• The Committee on Payments and Settlement
Systems (CPSS).
These Standing Committees attempt to prevent
financial crises and make policy recommendations on
how to structurally improve systemic stability on a
global scale.
In addition, the IMF and World Bank are currently
developing new guidelines for nations (e.g. a manual
of best practices in sovereign debt and risk
management using a balance sheet framework). The
ultimate aim of all these guidelines and standards is to
improve the minimum infrastructure of institutions and
markets. The supervisory agencies (e.g. the central
bank supervision function and the financial services
supervisor, or an integrated supervisory agency) have
an important responsibility for ensuring that these
minimum infrastructure requirements are indeed fully
implemented and enforced.
3.2 Enhancing market discipline
and sanctions
The discipline and sanctions of the market can be
enhanced in a number a ways. The key concepts in this
respect are competition and disclosure.
Financial Regulation in South Africa: Chapter 5
3.2.1 Encouraging competition between
financial intermediaries and
securities markets
Competition among financial institutions has the
advantage of lowering the costs of finance for the
public and removing inefficient institutions from the
marketplace (called “creative destruction”) which in
turn may reduce systemic risks in the long term. The
regulatory authorities have an obligation to encourage
competition to the highest degree as long as systemic
risks are within accepted boundaries.
The cutting edge of competition between the banks
and the securities markets is probably at the short end
of the yield curve: i.e. money-market funds (retail
investors) and the commercial paper market
(wholesale investors). Usually the complaints of banks
are that this competition in the money market is
“excessive”, “unnecessary”, and even “unfair” to the
unsophisticated small investor. However, this need not
be the case for the following reasons:
• With the development of financial conglomerates,
competition is not really between banks and
securities firms, as both are divisions in same
group. Any undue competition is therefore within
the group, and managements themselves can
determine the degree of participation in these
markets at the ruling price levels. “Excessive”
competitive pricing need not be followed, if such
prices are unsustainable in the medium or longer
term. What may happen is a reduction in the profit
margin as a result of healthy competition between
banks and the securities markets. Neither the
authorities nor the consumers are likely to object to
this competitive element.
• To reason that there is no need for money-market
funds because bank deposits can fulfil this task
equally as well, is incorrect from a risk/return point
of view. Some investors with a low risk preference
may favour bank deposits, but others may feel they
can easily accept the implicit market risks of a
money-market fund provided they are accordingly
compensated with a higher yield.
• For the truly unsophisticated retail investor,
91
 money-market funds are an unlikely investment
avenue, as the minimum investment in these funds
is often higher than the amount these people
normally save. Moreover, even if the minimum
investment threshold was low enough for them,
financial advisers (and their compliance officers!)
are bound to discourage such investments.
• Similar arguments are applicable to commercial
paper issues. Clearly, a competitive market in
commercial paper will reduce the interest margin
on corporate bank business, but such competition is
an advantage rather than a problem for the
regulatory authorities and the investing public.
Today, the regulatory authorities worldwide are
encouraging the development of their securities
markets, mainly for reasons of financial stability
policy and to improve the cost-efficiency of their
financial systems. As technology and financial
engineering improve, the relative importance of banks
and their role in the financial system becomes smaller.
The banks’ answer to this development is to transform
themselves progressively into financial conglomerates,
which service their clients over the full spectrum of
financial products and services.
3.2.2 Promoting direct financing through the
securities markets for higher risk
business
Considering the fact that the essence of banking is the
accepting of deposits (that are redeemable on demand
at par value plus interest) from the general public, there
is a relatively low risk threshold for deposit-taking
institutions. In contrast to securities firms, banks have
money-certain liabilities but uncertain (even
unmarketable) assets on their balance sheets. Therefore
if a sudden financial crisis hits the banks it is far more
serious for them than for the securities markets, as
banks have firm commitments to depositors. In fact,
the higher the market risks, the more attractive the
capital markets. The big advantage of the securities
markets is that its investors know, and have decided so
themselves, where their money is invested, but bank
depositors are not informed about the asset
92
management strategies of their banks. Therefore, one
possible solution is to finance very risky investment
projects such as venture capital projects or micro-
lending schemes for upcoming entrepreneurs through
the capital markets6. This financing can either take the
form of equity or bond financing.
From a regulatory viewpoint it is crucial that the
securities markets should be placed on a competitive
footing vis-à-vis the banking industry. If investors are
more prepared to accept the implicit market, credit and
liquidity risks of their investments, the financial system
will be more stable. Moreover, during periods of
financial distress, systemic risks are usually better
secured if the financial system rests on two strong pillars,
namely financial intermediation and securities markets.
The central bank can play a powerful role in the
development of securities markets. It can do so mainly
by removing the regulatory constraints that limit their
development, and also by encouraging competition
both between various types of financial institutions
and between local and foreign suppliers. For example,
the definition of deposit taking in banking legislation
should not be so constraining that it adversely effects
the development of the commercial paper market.
Likewise, the regulatory constraints placed on money-
market funds should not make these investments a
priori uncompetitive vis-à-vis bank deposits.
3.3 Improving the supervision,
monitoring and enforcement
capabilities of all players
In contrast to popular belief, the authorities are not
solely responsible for the supervision, monitoring and
enforcement of good corporate governance rules,
minimum standards and official regulation. Financial
market participants also play a major role in this
respect. For example: directors of financial institutions
have to ensure that corporate governance rules are
enforced in their organisations; management has to see
6
War bonds, not bank lending, were the instrument used in the
past. Likewise, the financing of micro-lenders may also be
achieved by means of bond financing than, for instance, by
coercing the banks or pension funds to invest in such projects.
Financial Regulation in South Africa: Chapter 5
to it that compliance takes place; internal and external
auditors have a great responsibility for monitoring and
enforcement; the markets reflect the risk
characteristics of banks through the pricing of
subordinated debt capital; last but not least, the
financial press has the important task of ensuring
sensible disclosure and reporting.
3.3.1 Enforcement
Even if the regulatory regime of a nation is well
structured and supported by supervisory agencies of a
high calibre, regulation will still be less effective if the
rules and regulations are not properly enforced. This
was again painfully true towards the end of the 1990s,
particularly after the financial crises in the Far East.
In principle, enforcement operates at various levels,
involving ultimately all the abovementioned role players
in the market. Firstly, market sanctions discipline
individuals and institutions. However, to be effective the
markets need disclosure, as the healing impact (through
competition) of markets is only possible if wrongdoings
are known. For instance, the requirement that generally
accepted accounting policies are to be followed is a
powerful disclosure rule (and enforced by the auditors).
The financial press also plays an important role in
supporting market sanctions, again through their ability
to disclose wrongdoings. Secondly, corporate
governance rules force directors to take effective steps if
regulations are breached. If they do not, investors can
sue them in their personal capacity7. Thirdly,
compliance officers have to ensure that the spirit and
letter of the regulations are enacted throughout the
organisation. Fourthly, auditors (particularly external
auditors, because they can be sued for compensation)
have a role in ensuring that regulations are enforced in
line with boards’ instructions. Furthermore, the audit
committee not only monitors the firm, but also plays a
part in monitoring the board itself.8
7
In practice, to sue directors in their personal capacity is still a
very rare event, but there is no obvious reason why this may not
change in future.
8
This is one of the reasons that the Chair of the Board is not
allowed to be a member of the Audit Committee – at best the
chair can attend as an observer.
Financial Regulation in South Africa: Chapter 5
A major difficulty in enforcement starts when the
board of directors and senior management are not
“suitable”. In essence, the underlying question is:
“who guards the guards?” Although the authorities
would prefer a market solution to this problem (i.e.
market sanctions), they cannot close their eyes to the
fact that they have granted the licence to undertake,
say, banking business. The regulatory authorities have
to ensure that directors and management are suitable
before they can issue such a banking licence, but at
what level of incompetence do they interfere? The
problem becomes even greater if there is, or was, an
ideological (political) link between the ruling
government party and bank directors (e.g. Indonesia,
1998). Close links between political power groups and
bank directors can create serious systemic risks for
many years to come,9 as bank staff appointments may
be to some extent based on party loyalty rather than on
competitive financial skills. If management cannot
distinguish between good and bad credit during the
good times, the central bank will have to do so during
the bad times (i.e. either with lender-of-last-resort
facilities or even lifeboat assistance to avoid systemic
failure). The key question remains, however, at what
level of incompetence do the regulatory authorities
revoke the licence of a firm or require a major change
in the composition of the board of directors?
3.3.2 Consolidated supervision of financial
conglomerates10
This regulatory challenge was extensively researched
by the BIS De Swaan Committee in 1995.11 In this
section attention will only be given to the typical
regulatory concerns in respect of financial conglomerate
structures and the possible options the regulators have
regarding how to cope with these concerns.
9
After the ruling party has been replaced, bank management may be
subjected to “unusually stiff” competition, as the “normal”, easy
business from friends in government is no longer forthcoming.
10
Based on Falkena, H.B. et al., An inquiry into the regulation and
supervision of financial conglomerates, Pretoria: The Policy
Board for Financial Services and Regulation, 1998, pp. 1–9.
11
Tripartite Group of Bank, Securities and Insurance Regulators,
The supervision of financial conglomerates, Basel: Bank for
International Settlements, July 1995.
93
Regulatory concerns
In the regulation of financial conglomerates, the
authorities are primarily concerned with (i) contagion,
(ii) transparency and (iii) autonomy. The key issues with
respect to each of these topics are summarised below:
(i) Concerns about contagion
Without appropriate regulation at group level, the
problems of liquidity or solvency throughout a
conglomerate will be magnified if market participants
are allowed to do the following:
• Regulatory arbitrage: Without a lead-regulatory
structure, the total risk exposure of a group (local
as well as abroad) can be disguised (e.g. as
happened in the case of BCCI).
• Granting excessive credit lines to selected third
parties: Without a limit on credit exposure to
clients, the diversification requirement – which is
the basis of credit risk management – is seriously
undermined.
• Granting excessive loans to connected parties:12
Connected parties are often in a position to
influence the policies and decisions of financial
institutions. Accordingly, large loans to connected
parties may be particularly risky.
• Executing high-risk business within low-risk
institutions: This is easier in financial groups than
in specialist financial institutions. For instance, the
management of a specialised low-risk financial
institution (say a building society) is unlikely to
handle high-risk business (such as the financing of
venture capital projects).
• Double gearing of capital between financial
institutions: For example, if bank deposits are used
to fund a long-term loan to an insurance
undertaking, which in turn follows up a rights issue
of that same bank, the double gearing of regulatory
capital is bound to occur (such an arrangement is
usually handled indirectly through a non-financial
company in order to bypass the restrictions of
banking regulation). Eliminating this double-
12
Connected parties may include shareholders, other group entities,
the directors and managers of all group entities, and perhaps
other of the business interests of those directors and managers.
94
counting of a group’s capital may result in the net
capital of the group being less than the sum of the
capital of the individual institutions. This double
gearing of capital creates a serious potential
contagion problem.
• Invalid assumptions about the mobility of capital:
Surplus regulatory capital in one subsidiary is used
to cover a capital shortage in another subsidiary,
despite the fact that the capital is not mobile. As a
result the group’s net capital is insufficient.
(ii) Concerns about transparency
The complexity inherent in financial conglomerates,
particularly if they conduct international business,
often diminishes transparency. The key supervisory
concern in this regard is transparency: i.e. supervisors
should be comfortable with their understanding of the
corporate and managerial structure. Structures where it
is not clear which shareholders (either legal entities or
individuals) and which managers exercise control over
a conglomerate and its component entities and which
parties have financial responsibility for the component
regulated entities, should be prohibited or discouraged.
Typical problems encountered by the regulatory
authorities in this area are:
• Lack of public disclosure: A financial group makes
it difficult for rating agencies or the securities
markets to evaluate an institution (e.g. the extensive
use of off-balance-sheet financing structures).
• Use of bearer shares: Ultimate ownership of a
financial institution is disguised by way of bearer
shares or similar vehicles (e.g. nominee company
structures).
• Insufficient disclosure to supervisors: A financial
group reports to various supervisory authorities on
a “solo” basis only and not on a consolidated group
basis.
• Non-standardised accounting rules: Different
accounting rules are used within a group
(particularly between local and foreign branches).
• No lead-auditors: Different external audit firms are
used within a group and may even report on
different year-end dates (i.e. no lead-auditor
structure and no accounting uniformity).
Financial Regulation in South Africa: Chapter 5
• Arbitrage between different regulatory accounting
principles: These principles may differ between
local and foreign supervisors, and institutions can
exploit these differences to their advantage (e.g. in
areas such as provisions, valuations, deferrals and
treatment of off-balance-sheet items).
(iii) Concerns about autonomy
A regulator has to ensure that the legal and moral
duties of directors and managers of each entity in a
group are clear and are carried out. Management has to
act fairly in situations involving conflicts of interest
(of which there are potentially more in a conglomerate
structure). The following arrangements are particularly
difficult in this context:
• Low Chinese walls: Directors and senior
management do not respect the Chinese wall
structures. If these walls are too low (even middle
management can peer over them), this may not
only encourage insider trading (where, for instance,
information of the credit division is shared with the
investment division), but could also result in
serious systemic risk exposures (e.g. Barings Bank
had no proper Chinese wall between the trading
room and the back office).
• Obscure mixed-activity groups: In financial groups
where the parent company is a non-financial
institution abroad the supervisory authorities may
have great difficulty in determining the ultimate
line of de facto authority and responsibility.
• Connected parties receiving credit at artificially
low rates: Where credit is granted by a financial
institution to a connected party at below market
rates, a serious conflict of interest will often arise.
• Significant change in business mix: After
authorisation has been obtained, the business mix of
a group changes substantially, resulting in major
changes in, for instance, ownership and management.
Regulatory options
To address the abovementioned concerns, the
regulators have a number of basic options available. In
essence they have a choice between consolidated,
separate or “solo plus” regulation. Each of these
regulatory options will be briefly discussed.
Financial Regulation in South Africa: Chapter 5
(i) Consolidated versus separate regulation
In principle, regulatory authorities have a choice of
two basic models of regulating financial
conglomerates. Either they select consolidated
regulation, which implies that regulation is applicable
to all group members engaged in financial activities, or
separate regulation, which tries to insulate (ring-
fence) the regulated entity from other group members,
and each activity is regulated separately. Generally
bank supervisors have been in favour of consolidated
regulation, while investment and insurance regulators
favour the separate regulation option.
The preference of bank regulators for consolidated
regulation is not accidental. In contrast to investment
and insurance regulators, bank regulators are heavily
involved in payments systems and the implementation
of monetary policy. Accordingly, bank regulators want
explicit authority over entities closely related to banks.
Moreover, contagion is regarded as such a grave
concern in banking that it justifies the extension of
regulation on a groupwide basis to include, for
example: capital-adequacy requirements; large credit-
exposure limits; foreign-exchange position limits;
shareholder, director and senior manager suitability
standards; and regulatory reporting and public
disclosure standards.
Separate regulation is usually preferred by
investment and insurance supervisors, as this option is
based on the principle of some activities best being
regulated (e.g. dealings with retail customers), with
other activities best being left unregulated. Under a
separate regulation regime the concerns about
contagion, transparency and organisational structure
are addressed by requiring additional capital (often in
an amount equal to the exposure itself), establishing
limits (or other restrictions) on exposures and type of
transactions, and setting suitable standards for
shareholders and management.
In practice, time and place will influence the
ultimate choice of regulating a financial conglomerate.
Although both options have their advantages and
disadvantages (see Table 5.1), the greater
sophistication of financial markets makes it
95
increasingly difficult to insulate a regulated entity
within a group. Moreover, contagion can result from
the public perception of an exposure. Even a wrong
perception by the public can result in a liquidity crisis
or a crippling loss of business for a regulated entity,
initiated by events elsewhere in a group.
(ii) “Solo plus” regulation
“Solo plus” regulation13 tries to obtain a middle
position between the (theoretical) extremes of
consolidated and separate regulation. Under “solo
plus” regulation there is no need to have a single
prudential regulatory agency, but instead use is made
of lead regulators (which is already the norm in many
countries)14. The lead regulator would be responsible
for taking a groupwide perspective of the risk profile
of a financial conglomerate and for co-ordinating the
process of supervision, both on a regular basis and in a
crisis. A lead regulator would also be responsible for
assessing the capital adequacy of a group as a whole,
13
As supported by the Basel Committee, IOSCO and EU
Commissioners.
14
The lead regulator (convenor) would usually be the regulator of
the parent company of the financial conglomerate.
Table 5.1: Advantages and disadvantages of consolidated regulation and separate regulation
Advantages
Consolidated regulation
• Addresses consistently the concerns of contagion in
a financial conglomerate
• Fully harmonises the approaches of consolidated
supervision and consolidated accounting
• Enhances transparency and public disclosure
• Addresses the risk characteristics of the institution
as a whole
Separate regulation
• Harmonises fully with the functional approach to
financial regulation, and therefore enhances the
efficiency of separate financial entities
• Supports explicitly the autonomy concerns of
different regulated functional entities
• Lessens co-ordination and authority concerns
among regulatory agencies
96
transmitting and requesting relevant information to
and from other supervisors, and generally co-
ordinating any necessary actions involving more than
one supervisory agency.
Under the “solo plus” regulatory approach, capital
requirements are related to the balance sheet positions
of each component of a group (the “solo” component)
after which adjustments are made with a view to the
conglomerate as a whole (the “plus” component). This
would eliminate, for instance, any double-counting of
capital within a group.
(iii) The concepts of “consolidated supervision”,
“accounting consolidation” and “solo plus”
The term “consolidated supervision” means a
qualitative assessment of the overall strength of a
group to which a supervised institution belongs and
the evaluation of the potential impact that other group
companies may have on the authorised institution.
Consolidated supervision also takes into account the
activities of group companies which are not included
in the consolidated returns, for example industrial or
insurance companies which would be excluded
because the nature of their assets would not make their
Disadvantages
• May be burdensome and even create competitive
disadvantages for otherwise unregulated entities
• Requires extensive co-ordination and even
modification of responsibilities among regulatory
agencies
• Results in transparency problems
• Has difficulty in detecting problems in overall
organisational and management structures
• Addresses contagion problems in a fragmented way
Financial Regulation in South Africa: Chapter 5
inclusion meaningful. In exercising consolidated
supervision, the activities of group companies are
taken into account to the extent that they have a
material bearing on the reputation and financial
soundness of the supervised institution in the group.
The purpose of consolidated supervision is not to
supervise all the companies in the group to which the
supervised entity belongs, but to supervise the
supervised entity as part of the group.
A distinction must be made between consolidated
supervision and accounting consolidation. The latter
implies the preparation of consolidated accounting
returns covering a group or part of a group.
Accounting consolidation may be the basis for
applying prudential requirements to the group,
although accounting consolidation is not a
precondition for the application of consolidated
supervision as there are alternative techniques
(solo-plus measures), which may also be applied.
Solo-plus measures may be applied to group members
which are not included in the consolidation in order to
monitor and/or control the exposure of the supervised
entity to such entities.
The tools applied in consolidated supervision may
include any of the following:
• Impairment of capital for intra-group exposures
and/or holdings in other supervised entities;
• limitations on holdings in other supervised entities;
• the calculation of capital requirements to cover
market risks on a groupwide basis;
• calculation of capital requirements which may be
based on consolidated figures, through aggregation
of the capital requirements of the different group
members, or through deduction methods;
• groupwide application of limits on large exposures
in the banking book and the capital requirements
against large exposures in the trading book;
• review of intra-group transactions;
• assessment of the adequacy of internal control
mechanisms on a groupwide basis (especially
control over the information which will be relied
upon for the application of consolidated
supervision);
Financial Regulation in South Africa: Chapter 5
• access to information and power of inspection in
all areas of prudential supervision, applicable to
supervised and to unsupervised group members;
• regulation of group structures, ensuring that the
group structure does not prevent effective
supervision;
• assessment of distribution of capital among group
members within a group.
3.3.3 The supervision of complex groups
Complex groups are large financial conglomerates that
operate in various functions and in various jurisdictions.
For example in the UK and US the regulators have
classified their largest financial institutions as “most
complex”. In the UK these firms include about 50
institutions (including all big clearing banks, and the
major banks and investment banks from the US, Europe
and Japan), while in the US they include the 30-plus
internationally active banking giants.
In various countries, notably Australia, Canada, the
Nordic countries, the UK and the US, complex groups
are now supervised by dedicated teams of (between
two and twelve) supervisors, who concentrate entirely
on one financial conglomerate. Once a financial
conglomerate begins to look at its risk on a global,
groupwide basis, the balance sheet of one part of the
group becomes progressively less important. For a
large globally active bank, a typical trading book could
contain half a million open positions. A trade made in
one market may be hedged in another market halfway
across the world. Similarly, management lines may
cross continents. The upshot of this is that regulators
have recognised that they can only scrutinise a
complex financial conglomerate’s operations by using
the firm’s own systems and data.
The level of resources dedicated to risk management
and control processes is large in a complex group,
particularly compared to that of the official
supervisory staff (which is usually tiny and may only
total 3 man-years for a particular complex group). As a
result the focus of supervision is shifting away from
individual spot inspections to verifying the group’s
own risk-management systems. The emphasis in the
97
supervision of complex groups has started to centre on
the following type of questions:
• Is top management up to the job?
• Are the group’s risk management systems of
sufficiently high quality?
• Are the group’s control systems acceptable?
• What standing do control and compliance people
have in the organisation?
• Is the degree of disclosure acceptable (notably to
creditors)?
• Why are risk exposures, and thus profits, shifted
between components of the group (notably
between banking and insurance)?
Once the supervisors are happy with the attitude of
top management and confident about the quality of
internal audit, compliance and risk management, they
have a basis for leveraging off what the group is doing
and to use the output of the group’s management and
control systems.
As financial conglomerates become more globalised,
more integrated with financial markets, and place
greater emphasis on centralised risk-management and
economies of scale, the supervisors can no longer rely
on lead supervision structures. For instance, the UK
has moved to “enhanced” lead supervision, which
entails that the solo regulators of each wing of a
financial institution should agree on a co-ordinated
programme of supervision. This supervisory structure
is designed to concentrate resources on the group’s
most risky activities. Accordingly, the supervisors in
banking, insurance, securities trading and fund
management are combined into a single team, creating
essentially a bespoke micro-regulator, dedicated full-
time to one institution. The UK regulatory authorities
have also moved towards risk-based regulation and
supervision whereby differentiations are made
between financial firms according to their risk
characteristics, and supervisory resources are
concentrated more on those institutions judged to be
most at risk.
Although “enhanced” lead supervision creates a
single point of contact with the regulator it also entails
the danger that the supervisory teams will lose
98
objectivity and begin to see the world through the
conglomerate’s eyes, or that the supervisors will have
too much concentration of power. To address these
two potential dangers it is important that (i) examiners
are rotated at least, say, every three years, that (ii)
group supervision teams are carefully monitored by a
quality control team and that (iii) there are sufficient
checks and balances in place to avoid misuse of power
(e.g. appeal to tribunal).
3.3.4 Highly geared off-shore institutions and
liquidity risk
Fluctuations in market liquidity are of considerable
systemic concern to the authorities, given the
increasing role of the securities markets for funding,
liquidity management and asset sales by banks. Today
banks and other financial institutions are often heavily
involved in the issuance of, and trading in, securitised
assets. Some of the major securities markets’
participants are even non-financial institutions with
highly leveraged positions. Should such institutions be
confronted with a sudden collapse in market liquidity,
the external effects could be similar to a bank crisis.
Securities markets are prone to episodes of
illiquidity and market failure. A liquidity crisis can be
triggered by a sudden rerating of sovereign risk, as
was the case for instance after the Russian debt
moratorium in 1998. As a result, the effective
exchange rate of the rouble depreciated sharply, while
equity and bond prices worldwide were badly affected.
The perceptions about credit risk worsened suddenly,
in turn resulting in an extreme liquidity preference and
a general unwillingness to deal in corporate bonds. As
liquidity plunged, price volatility rocketed, implying
an even higher premium on liquidity. Consequently
spreads in the securities markets widened abruptly,
which combined with the natural herd instinct of
dealers, caused a flight to quality securities at the cost
of higher-risk and/or lower-liquidity assets. For an
unregulated hedge fund such as Long Term Capital
Management (LTCM), with a leveraged position of
50:1 across a diversified range of financial markets,
such a liquidity shock proved too much in 1998.
Financial Regulation in South Africa: Chapter 5
Private-sector banks, under the guidance of the US
Federal Reserve, had to undertake a rescue operation
to preserve orderly market conditions.
Although markets, unlike banks,15 may become
illiquid but cannot become insolvent, the end-effect of
a liquidity crisis, with the massive impact of forced
leveraged sellers, is still similar to a bank failure.16 If
LTCM had not been rescued, a process similar to a
contagious bank run could have ensued,17 with first the
institution itself and then the most exposed creditors
being starved of liquidity and forced to sell assets in a
“fire sale” manner18. Given an underlying weakness in
market liquidity, this would have exacerbated the
effects of the simultaneous closure of positions would
have prompted severe market disruptions.
As traditionally uncorrelated markets became highly
correlated in the wake of a liquidity crisis, the market,
liquidity and credit risks became far more correlated.
In these circumstances, market makers are no longer
willing to quote doubles for fear being caught at the
opposite side of the market. Accordingly the market
makers adopted a defensive approach which
aggravated the liquidity crunch.
It is difficult to regulate hedge funds from a financial
stability viewpoint, because they are usually non-
financial institutions positioned in offshore financial
centres. Accordingly hedge funds are extremely
mobile internationally and fall outside the regulatory
regime normally applicable to financial institutions.
Nonetheless, considering their size and the fact that a
securities market collapse can so easily lead to a
15
Unlike sight deposits at banks, there is no guarantee of a fixed
rate at which securities can be liquidated immediately, although
short-term high-quality debt securities approximate to this.
16
Sharp declines in liquidity may lead to cash-flow difficulties
owing to inability to sell, or increased difficulties in obtaining
credit due to the lower value of collateral. Moreover, the process
of securitisation has entailed a much greater reliance on securities
markets by a range of institutions.
17
Had LTCM been put into default, its 75 counterparties would
have rushed to “close-out” hundreds of billions of dollars of
positions, causing massive illiquidity and price shifts, harming
both the counterparties and other market participants
18
Davis, E.P., “Russia/LTCM and market liquidity risk” in The
Financial Regulator, Vol.4, No.2, London: Central Banking
Publication , 1999.
Financial Regulation in South Africa: Chapter 5
liquidity crisis for banks, the regulatory authorities
(BIS) decided to tighten up the capital requirements
for banks granting credit lines to hedge funds. This
latest measure is likely to reduce the financial gearing
of hedge funds to a significant extent, and so
contribute to greater financial stability in general.
3.3.5 The financial press and
information disclosure
One of the cornerstones of the regulatory regime is
disclosure. Or as the saying goes: “Sunlight is the best
antiseptic!” In the financial markets the financial press
is an extremely important role player as well as a
bridge between consumers and producers. For
consumers to sift sensible from rather useless financial
information is often a hard or even impossible task.
The small print on financial contracts is often too
small, too legalistic and too long to be of much help to
consumers. In this type of “information overload”, the
authorities and the press can be of great assistance to
consumers by digesting the information supplied and
summarising the results in a user-friendly form. Better
information and disclosure also reduce the moral
hazard of the authorities and are a powerful antidote to
forbearance. In this respect, a number of countries are
experimenting with some new ideas:
• Competitive prices for similar financial products
can be placed on an Internet site on a daily basis.
This information should be supplied, through the
compliance office, by all product providers. The
financial press now immediately possesses a
powerful database on which it can base its advice
to the public. The FSA in the UK is working along
these lines today.
• The credit rating of financial institutions can be
enhanced by the official ratings of the regulatory
authorities. Although certain information supplied
to the supervisors is classified, this need not
prevent the authorities from doing a general
evaluation of regulated institutions and publishing
the results of such research. In fact, the financial
industry together with the authorities can work out
for public consumption a rating analysis based on
99
 the official returns. In the US banks are already
rated in five classes by the authorities and this
information is made public.
• Consumers may want to give their business to
financial institutions that support their social
preferences, even if the returns on their
investments may be slightly less attractive. Some
consumers, for instance, may want to support only
those banks that sponsor sport, while others may
feel that their support should go to banks that
support the social upliftment of their local
communities. How much of a bank’s spending is
done on sport and how much on social goals? The
public (i.e. in effect the press) wants to know, and
the authorities can be of help by simply collecting
the available data.
• Consumers may want to know, on a competitive
basis, the quality of financial advice given by
evaluating, for instance, the lapse rates of long-
term insurers, or they may want to know the claim/
payout rate of short-term insurers.
Before signing a financial contract it is helpful for
the consumers to receive a short summary of the
essentials of the contract (called a “health warning”). In
the UK this is known as the “Key Features” of a
contract on a product and must be given to the
consumer before a purchase is made. But even before
they consider such a “warning” on contents, consumers
should also be aware of the competitiveness of that
contract in the broader market. With the technology of
the Internet available, the authorities can do a lot more
than they currently do to make markets more
competitive and transparent. In this regard, the FSA in
the UK plans to issue comparisons between similar
products issued by different firms.
3.4 Promoting monetary and
financial stability
Recognising that regulatory provisions can have
systemic implications with macroeconomic effects
raises two questions:
• Should central banks have a role in designing
regulatory regimes?
100
• Should central banks have some advisory role
when it comes to enforcement?
The precise role of the central bank in the promotion
of financial stability still seems subject to a significant
degree of uncertainty. Recent experience has taught
(painfully) that credit risk, liquidity risk and market
risk are not separable and additive, but instead have
proved highly interactive.19 If the central bank is at the
heart of liquidity management, how do other
regulators manage credit-risk and market-risk
exposures in isolation?
The key question in central banking today is
therefore whether monetary policy should respond to
asset price and exchange rate movements. For
instance, should the central bank try to prick an asset
price bubble in the stock market with a more stringent
monetary policy stance (e.g. higher discount rates) or
higher prudential requirements (e.g. higher capital
requirements for banks) in the hope that this will
enhance overall financial stability in the long term.
The answer to this question is also of critical
importance for the regulatory architecture of a country.
If the central bank has, in addition to monetary
stability, the responsibility for financial stability, it
will then virtually and implicitly become the key
institutional regulator, in addition to being the
monetary authority. In fact, in such a regulatory
architecture the central bank is likely to be the lead
institutional regulator, particularly for complex
financial institutions.
To date, no consensus has been reached among
central bankers on this important matter. The aim of
this section is to summarise the train of thought on this
topic and to hint at a possible direction of development
in this area.
3.4.1 The conventional view that central
banks should limit themselves to
monetary stability only
There are strong arguments why central banks should
19
Credit risk causes liquidity to disappear, in turn generating price
movements significant enough to have effects on perceptions of
market risk.
Financial Regulation in South Africa: Chapter 5
focus exclusively on price stability. The main reasons
are as follows:
• Price stability is the best protection against
financial instability. There is a close long-term
relationship between inflation and asset prices.
Accordingly, monetary policy should only respond
to asset prices to the extent that they provide
information about future inflation.
• Fundamental value is extremely hard to assess. No
central banker can be certain whether a jump in
asset prices reflects an increase in productivity or a
bubble.20
• Ill-designed safety nets (notably the central banks’
lender-of-last-resort facilities and public-sector
sponsored deposit-insurance schemes) can exacerbate
instability. According to this view, central banks
should not involve themselves with deposit insurance
(it should be a private sector arrangement, if required
at all), while its lender of last resort arrangements
should be limited to collateral lending (implying that
only illiquid, but solvent banks can make use of this
distress facility21).
• Sudden withdrawal of liquidity or a sharply
reduced scope for gearing can result in even more
fragile balance sheets for banks. Therefore central
banks should not actively interfere in the liquidity
supply of institutions or markets (i.e. after it has set
broad prudential requirements in this respect).
• Even if a central bank wishes to prevent a financial
imbalance from building up, by the time it forms a
firm judgement about the existence of an
imbalance, it would be too late. Trying to prick a
bubble in its later stage risks precipitating the
financial instability it is intended to avert.
20
Central banks always deal with uncertainties of one kind or
other. If they do make estimates about the potential output gap
in their inflation forecast, they can make projections about
fundamental asset prices and exchange rates as well. Indeed, the
uncertainty about the valuation of asset prices is arguably no
greater than the uncertainty about potential growth rates and
hence the size of the output gap which is at the heart of most
central banks’ inflation forecasts.
21
By contrast, insolvent banks should approach the Treasury, as
taxpayers’ money will unavoidably be involved in the bail of an
insolvent bank.
Financial Regulation in South Africa: Chapter 5
• The response of asset prices to monetary policy is
highly unpredictable and dependent on market
sentiment. A pre-emptive monetary tightening may
even boost asset prices if it strengthens the market
participants’ sense that the central bank has
inflation well under control.
• As no monetary authority can say with confidence
that an asset price movement is a bubble and not a
reflection of fundamental values, it becomes
difficult to persuade the investment public that
interest rates have to rise to resist surging equity
prices. In the end, bubbles are popular among
investors and particularly so if the authorities
support the markets during a “crash”, and do not
interfere during the boom (and thus let bubbles burst
on their own account). The markets love this kind of
asymmetrical asset price interference, and even
more so if paid for by others – such as taxpayers.
• The more the central bank becomes involved in
financial stability policy, the greater the likelihood
that it may lose some of its independence from
politicians, which in turn may adversely affect its
goal of price stability (as nowadays reflected in a
defined inflation target).
The above arguments are powerful indeed, but
doubts remain.
3.4.2 Arguments why central banks should
also be involved in establishing
financial stability
Over the past twenty years the world’s financial
system has been subjected to major changes which has
also changed the traditional character of central
banking. Financial systems today are market-led rather
than government-led. Most important, financial
liberalisation and innovation has not only resulted in
cheaper financial products and more choice, but has
also provided the means for increased liquidity and the
potential for leverage. In fact, the current system has
structurally increased liquidity and the potential for
financial gearing with major consequences for
financial stability (one of them being that there is now
far more fuel for the fire). All these changes imply
101
greater reliance on market forces, with resulting
“creative destruction” of institutions and markets. And
yet relying on market discipline alone to ensure the
necessary degree of financial stability, may no longer
be possible. The major reasons for the central banks’
possible involvement in financial stability centre on
the following arguments:
• Central banks, by their very nature, are heavily
involved in systemic risk management, and cannot
close their eyes to the fact that there is a close
correlation between monetary and financial
stability. Increased market volatility often results in
financial instability, which in turn results in
institutional distress, increased credit risks, more
insolvencies in general, later systemic distress, and
ultimately greater demands for liquidity through
the central bank’s lender-of-last-resort facilities.
Moreover, the implied option value of deposit
insurance rises during periods of financial
instability. The costs of the central bank’s safety
net arrangements are closely associated with the
phase of the financial cycle and thus financial
stability. To keep the costs of the safety net
arrangements within reason, the central bank has a
direct interest in financial stability, and should
react accordingly.
• Central banks face a major moral hazard in respect
of asset price movements, because they should not
interfere in an asymmetrical fashion in the financial
markets. If they are expected to supply extra
liquidity during a market crash (e.g. during the
1987 “melt- down”), they should also be able to
reduce liquidity deliberately at the height of
financial cycles.
• Market liquidity has a dangerous binary side – it is
either “on” or “off”. By contrast, the central banks’
liquidity policy could be one of “leaning against
the wind”. Liquidity policy is the key instrument in
any financial stability arrangements and the central
bank (not the Treasury) possesses these important
policy instruments. By taking more account of
asset prices, central banks can reduce the long-term
variability of inflation and output.
102
• Financial markets are usually very sophisticated in
assessing relative risks, particularly in respect of
instruments, debtors and counterparties. However,
markets are far less skilled in assessing absolute
risks, i.e. the phase of the business cycle and the
overall position of the financial environment.
Usually the central bank is in a better position here
than the markets, and it should use this information
for the benefit of national welfare.
• Even if the central bank is uncertain whether the
high level of asset prices is a reflection of
improved economic fundamentals or whether it is a
bubble, the monetary policy implication is not
much different: i.e. it should be tightened anyway.
Indeed, if it is a bubble, then a tightening of
monetary policy would help to contain it. If it is
instead a reflection of a stronger rate of
productivity growth, then the real equilibrium
interest rate would increase as investment
opportunities expand.
3.4.3 The current status of the debate whether
central banks should be involved in
active financial stability policy
The economy as a whole has a pressing need for both
monetary and financial stability. In essence, the
current financial system has two major weaknesses.
Firstly, risks tend to accumulate rapidly in the
upswing of the financial cycle (in line with increased
levels of business optimism), but during the
unavoidable recessions that follow such booms, these
risks start to materialise quickly. Damage is then done
to the financial system and it seems that the regulatory
authorities cannot rely on market discipline alone in
this respect. Secondly, the policy anchors for
monetary and financial stability are no better than the
ground in which they are secured. Inadequate
perceptions of risk and inflated asset values lead to
serious distortions in the financial system. If the
authorities do not address these distortions, the policy
anchors are secured in quicksand. Moreover,
particularly in developing countries, the regulatory
infrastructure is often still too weak to rely on market
Financial Regulation in South Africa: Chapter 5
forces alone. It seems that the impact of the above
arguments imply the following:
• There is a school of thought, if the central bank is
to be responsible for broad definitions of financial
stability, it must be a position to set, or have a
major influence on, capital requirements and hence
leverage of banks. In particular a more extreme
view argues that the central bank, in the interest of
financial stability, should set capital requirements
on a counter-cyclical basis.
• Globalisation has extended financial linkages
across institutions, markets and countries with
resulting capital flows. These often volatile flows
need the attention of the central bank, as even a
small change in the portfolio composition of fund
managers in the industrialised countries (the core)
can have a major impact on capital flows to
developing countries (the periphery). The exchange
rate value and hence price stability in the medium
term are directly influenced by these institutional
portfolio adjustments and this requires
international institutional co-operation, particularly
between international institutions such as the IMF
and developing countries. In such agreements the
role of central banks cannot be ignored.
• Financial stability rests on the three pillars of the
financial system, namely proper infrastructure,
sound markets and robust financial institutions.
Whereas monetary stability depends ultimately on
the interest rate, financial stability depends
primarily on prudential requirements and financial
gearing. It seems that the central bank has a key
role to play in reinforcing each of these three
pillars of the financial system.
• Central banks are involved in systemic distress
management, whether such distress flows across
sectors, across borders or over time. Usually
distress results from misalignments in
macroeconomic magnitudes such as consumption
and investments patterns, which in turn impact on
credit risks and insolvency.
In a nutshell, if central banks were to accept the
responsibility for targeting two ultimate goals, namely
Financial Regulation in South Africa: Chapter 5
monetary and financial stability, they would be de
facto heavily involved in financial regulation as well.
It then becomes crucial to distinguish clearly between
regulation and supervision (as discussed in the next
section). If financial stability is an objective, the
important policy instrument will be the setting of
prudential requirements for banks and investment
firms in order to constrain credit expansion and
financial leverage. In such a case the prudential
requirements would potentially have major
implications for the discount rate (i.e. the key
instrument of monetary policy) to ensure the
harmonisation of medium- and long-term price
stability. Accordingly, the latest efforts of the
Financial Stability Forum (BIS) go to the very heart of
central banking, as its recommendations centre on the
central bank’s ultimate objectives.
3.5 Regulatory arrangements
3.5.1 “Enhanced” lead regulation versus
functional regulation
Traditionally the supervision of banks and non-bank
financial institutions was clearly distinguished and
separated. Bank supervision was seen as a central bank
function. There were a number of powerful reasons for
this policy approach:
• The supervision of banks needed specialised staff,
which were more easily found in the central bank
than outside it.
• Combining oversight with the monetary policy
functions offered distinct advantages, especially
within an open and liberalised economy.
• The safety net arrangements of the central bank
were closely intertwined with the responsibilities
of the bank supervision department. Before the
central bank could decide on a lifeboat facility, it
depended on the bank supervision department for a
due diligence investigation.
• Banking supervision, crisis management and
lender-of-last-resort facilities were and still are
closely intertwined, particularly because: (i) there
is a lack of (perfect) information, making it
103
 difficult at times to know for sure whether a bank
is insolvent or illiquid; (ii) there are systemic
implications for other banks if a bank in distress is
not bailed out; and (iii) even if part of the banking
system is allowed to fail, the authorities may find it
is difficult to achieve their macroeconomic
objectives (because of a major loss of confidence,
i.e. the social costs of a bank failure22). Financial
distress management sooner or later involves the
central bank because of its key role in the payments
system and ultimately its role as lender of last
resort. The bank supervision department plays a
crucial role in supplying the required information
to the central bank.
• The (confidential) information about banks that the
central bank possessed and still possesses is also
used by the bank supervision department for
routine in-house operations.
However, since the mid 1990s a change in
philosophy has occurred vis-à-vis the role of the
central bank in bank supervision:
• Bank supervision and enforcement policies are
conceptually quite different from regulatory
policies. For instance, the central bank may change
the prudential requirements for banks, but the
monitoring, supervision and enforcement of such
regulatory changes are not necessarily a central
bank function.
• The creation of new financial instruments (owing
to the unbundling and rebundling of services) and
the offering of these financial hybrids by different
types of financial institutions have made integrated
regulation more necessary than in the past.
• As globalisation progresses worldwide, national
supervisors are likely to become less able to assess
the soundness of banks or the risks of systemic
contagion, because of their national orientation
towards supervision and regulation. For similar
reasons cross-border co-ordination is unlikely to
22
Expressed in social costs, a major bank failure cannot be handled
in isolation by an autonomous supervisory agency, as it also
involves the monetary authorities and often the Treasury as
well – inter alia because taxpayers’ money may have to be used
to bail out the bank.
104
fill these gaps, as the sharing of responsibilities
between home and host supervisors has proved
difficult. What ultimately is required are
multinational supervisory agencies that include
home and host country representatives of the
banking and the non-banking financial institutions.
• The lender-of-last-resort facility was never
intended to be limited to banks, as the central bank
may need to supply liquidity to any institution
experiencing difficulties that may create systemic
problems more specifically payments system
problems.23 The emergence of complex financial
groups has resulted in integrated financial-sector
supervisory agencies, which are combining
banking, securities and insurance supervision. Such
an integrated supervisory approach cannot be
operated effectively and efficiently by one specific
department of the central bank.
• Building supervisory capacity on an integrated
basis achieves important synergies and economies
of scale. Not only are the career progression
prospects in such a super-regulatory agency
attractive, but such a larger unit may reap
important benefits of economies of scale in areas
such as joint administrative and information
technologies. A larger unit also facilitates the more
effective deployment of staff.
• The establishment of currency blocs (and notably
the euro-currency bloc) implies a radical split
between policy making and supervision. In the EU
the national central banks handed over their
monetary policy to a super-national body (i.e. the
European Central Bank or ECB). However, the
supervision of financial institutions still remains a
national affair. For example the 11 EU countries all
have their supervisory agencies at national level,
whereas the ECB takes full responsibility for
monetary (and perhaps financial) stability.
• Some countries have established super-regulatory
23
A recent US example (in 1998) was the support given to Long
Term Capital Management, a highly leveraged non-financial
institution, by the Federal Reserve through the American banking
system. The support was required given the large exposures of
banks to Long Term Capital Management.
Financial Regulation in South Africa: Chapter 5
 agencies (such as the FSA in the UK). This implies
that bank supervision has to be taken out of the
central bank, to enable this function to be
integrated inter alia with insurance supervision.
• Consolidated supervision implies that banking and
securities business supervision become fully
integrated. In a complex financial group, the bank
supervision function probably becomes the lead
supervisor in respect of securities business and
insurance supervisors. Nonetheless, the traditional
boundaries between banking, securities and
insurance are becoming increasingly blurred.
• In complex financial groups there is a general
strategy to position the war chest of the group (i.e.
the surplus capital and reserves available for
takeovers and acquisitions) in the insurance
company, as this type of business is less risky and
more leniently regulated. Although jurisdictions
and functions may differ in the various strategic
business units of a complex group, the financial
risks (e.g. credit, currency or market risks) remain
the same. What is important is that, by means of
derivatives these risks (and therefore profits) can
be transferred throughout the group. Supervisors
have a better overview of such risk transfers if the
supervision is done on an integrated basis.
• A tendency is developing among governments to
allow central banks only to assist in bank bailouts to
the extent that such institutions are solvent.
Liquidity assistance is therefore on a strictly
collateral basis, and the final decision in this respect
depends on the governors of the central bank, not
the head of the bank supervision department.
In an effort to blend the advantages and
disadvantages of a super-regulatory agency, the
following structures are now developing in some of
the major industrialised countries:
• More and better-integrated autonomous
supervisory agencies are being created. These
agencies are, administratively, strongly connected
to the central bank, sharing for instance its support
infrastructure (e.g. data collection or administrative
support).
Financial Regulation in South Africa: Chapter 5
• The supervisory agencies tend to follow a
multidisciplinary approach: i.e. across functions
and across jurisdictions.
• The integrated agencies are politically transparent,
as any directives given to it by the responsible
minister are open to public scrutiny.
• The supervisory agency actively co-operates with
the central bank to provide professional expertise
on issues such as financial market stability and the
payment and settlement systems.
• While some supervisory agencies have become
more rules bound, central banks have often been
granted greater degrees of discretion (e.g. to ensure
financial stability).
• An integrated agency makes it possible to have a
single coherent financial services statute under
which financial conglomerates can be regulated.
• To integrate its own staff, the integrated
supervisory agency has to rotate the various
professional skills between the various functions
(e.g. banking and insurance supervisors may have
to change jobs after some time).
Given all the above arguments, a final note of
warning is in order – particularly for developing
countries where skilled resources are usually scarce.
Many developing countries struggle with problems
with retaining skilled labour in government
departments, inter alia because these resources are
relatively scarce in the first place and secondly
because the private sector is able to skim off the
cream by offering more attractive remuneration
packages. By contrast, an independent central bank
falls outside the public sector’s remuneration policies
and accordingly can compete head-on with private
banks for more expensive personnel. Any transfer of
bank supervisors to an integrated supervisory agency
would have to be undertaken with the greatest care, as
it may easily result in a reduction in banking
supervisory capacity. Indeed, the professional staff
may opt to leave rather than to lose the pay and status
usually associated with being a central bank
employee. But then again, personnel issues should
not cloud the overall strategic direction of the
105
authorities in the long run.24 Moreover there are of
course also the political implications of transferring
power from one authority to another (see Box 5.1,
which lists some of these aspects).
24
Some countries are appointing retired senior managers from the
private sector on an occasional basis to assist the supervisors in
their monitoring and enforcement tasks. This scheme seems to
operate very satisfactorily, because the appointed staff have
much in-house knowledge and experience, no great problems
with limited career prospects, and can be employed on a selective
basis as they do not want to be involved full-time anyhow.
3.5.2 Safety net arrangements
The safety net arrangements of the monetary
authorities (including the Treasury) embrace, in
principle, three components. Firstly, there is the
lender-of-last-resort facility of the central bank for
illiquid, but solvent, financial institutions. Secondly,
retail depositors may be compensated from a deposit-
insurance scheme if a bank becomes insolvent. Lastly,
insolvent financial institutions may be supported for
systemic reasons by the central bank or the Treasury.

Box 5.1: The political dimension of transferring bank supervision from the central bank
Transferring bank supervision outside the central bank has an important political dimension. For one, it implies a
lower institutional barrier between the politicians and the financial regulators. A balance of power as a counter to
populist day-to-day party politics demands a separation of powers*. For instance, in the South African context, the
State President appoints the governors of the central bank on a fixed five-year contract, while the independence of
the central bank is enshrined in the Constitution. By contrast, the National Treasury is a straightforward
government department headed by a political appointee (i.e. the Minister of Finance), who may leave his office at
any time (e.g. after a Cabinet reshuffle). Further, the central bank is of great importance in any country because of
the legal right to create money. One of the important issues arising from this right is whether this function should
fall under the ultimate control of the executive branch of government or whether parliament should leave this
responsibility to an independent, autonomous institution run by unelected people. The traditional argument in
favour of an independent central bank is that the power to spend money should be separated from the power to
create money. Numerous episodes in the world’s economic history testify to a government’s potential abuse of its
power to create money and a resultant increase in inflation (e.g. many governments have given way to the
temptation to reduce interest rates ahead of elections). Central bankers normally operate on a longer-term time
scale than politicians and therefore do not face the same temptation to relax policy to achieve short-term
objectives (in fact, the Governor of the SA Reserve Bank has suggested that increasing the governors’ terms of
tenure from the five-year political cycle would improve the autonomy of the Bank). By delegating decisions about
interest rates and other monetary matters to such an independent institution, with a clearly defined mandate,
society can hope to achieve a better inflation outcome over the longer term.
Generally in old established democracies, where effectively the “middle-class” rules, and where there is a
distinct separation of powers, the lowering of the political barriers may be less problematic – particularly in a
federal constitutional set-up as found in the US and now increasingly in the EU – than in developing countries
where the young democracies effectively represent the poor and often the unemployed.
Accordingly, the envisaged efficiency gains of a one-regulator structure in industrial countries may well turn out
to be inappropriate for developing countries, as short-term political opportunism may take its toll (note for instance
the recent experiences in Indonesia and Zimbabwe). Although private bankers may prefer (on a basis of principle)
that the structure of their regulators should mirror as closely as possible their own organisational structures, a
trade-off has to be made between the economic and political interests of society. These country-specific dilemmas
are one of the reasons that the one-regulator structure of the UK cannot simply be copied by developing countries
such as South Africa. In fact, not even the UK is of the opinion that their current regulatory arrangement of a
mega-regulator is an ideal export product.
________________________________
* For instance, the trias politica and upper and lower houses in parliament are just a few of the instruments used to ensure a
balance of power in the state and go back at least until the times of Montesquieu.

106 Financial Regulation in South Africa: Chapter 5

Lender-of-last-resort facility25
Similar to the current debate about whether the
monetary authorities should use discretion or rules in
financial stability policy (see Section (iv) below), there
is a debate whether the central bank should use
discretion in granting lender-of-last-resort (LOLR)
assistance to illiquid institutions or whether it should
stick to predetermined rules in such operations. LOLR
policies have typically three primary objectives:
• To protect the integrity of the payments system.
• To avoid runs that spill over from bank to bank and
develop into a systemic crisis.
• To prevent illiquidity at an individual bank from
leading unnecessarily to its insolvency.26
Countries approach the issue of discretion or rules in
LOLR operations in different ways. For example, in
the US the Federal Reserve Act (i.e. the 1991
amendment) severely limits the Fed’s discretion to lend
to undercapitalised institutions, and if such lending
would cause losses, the Fed needs reimbursement from
the Federal Deposit Insurance Corporation.
By contrast, the European Central Bank (ECB) is
almost exclusively focused on monetary policy and its
role vis-à-vis the national European central banks is one
of ambiguity. Being largely based on the German central
bank system, the ECB would most likely consider
LOLR assistance if such operations only take place on a
strictly collateral basis against good quality paper.
In the German monetary system the LOLR functions
are the responsibility of the Liquidity Consortium
Bank (in which the Bundesbank holds a 30 per cent
interest), while the Bundesbank itself focuses
exclusively on price stability.
In the UK the Bank of England (BoE) will grant
LOLR facilities to institutions on a discretionary basis,
but only against good collateral. In the case where an
25
This section is based on Prati, A., and G. Schinasi, “Will the
European Central Bank be the lender of last resort in EMU?” in
Artis, M., A. Weber and E Hennessy (editors), The Euro, A
challenge and opportunity for financial markets, London:
Routledge, 2000.
26
By contrast, the primary objective of a deposit-insurance scheme
is to prevent self-fulfilling runs on deposits and to provide a safe
asset to small savers.
Financial Regulation in South Africa: Chapter 5
illiquid financial institution drifts into insolvency, funds
have to be supplied by the Treasury, which then also
wants control over how these funds are to be used.27
In South Africa the SA Reserve Bank (SARB) has
discretion in granting LOLR assistance but only
against collateral (this assistance has, at times, been
supplied by the authorities at virtually zero cost). As in
the UK, the SARB has to look for financial assistance
from the Treasury if it wants to bail out an insolvent
financial institution.
This section will briefly evaluate the various
approaches to LOLR operations by firstly emphasising
the underlying principles of LOLR assistance,
secondly by distinguishing between the “market-
operation” and “banking-policy” approaches to LOLR
assistance, and lastly by considering the relative
advantages and disadvantages of discretion or rules in
LOLR operations.
(i) The principles of LOLR operations
Bagehot (1873) set out the benchmark for LOLR
operations more than a century ago. The application of
his doctrine would require a central bank to –
• make LOLR facilities available to the whole
financial system, but lend only to illiquid
institutions that are solvent;
• let insolvent institutions fail;
• lend speedily;
• lend only for the short term;
• charge penalty interest rates;
• require good collateral; and
• announce these conditions well in advance of any
crisis, so that the market would know exactly what
to expect.
These best practices are generally still considered
valid as an ideal. Strict adherence to the Bagehot rules
has three major advantages. Firstly, as a loan is only
granted to solvent institutions, the central bank is not
confronted with the moral hazard of bailing out
institutions that do not deserve such assistance (but
may have to obtain it nonetheless for systemic
27
With potential negative implications in terms of time delay
and political interference – indeed, “he who pays the piper
calls the tune”.
107
reasons). Secondly, as lending takes place against good
collateral, the central bank’s balance sheet position is
not necessarily adversely effected. Thirdly, because the
lending is only for short periods, the inflationary
consequences of LOLR intervention are limited.
However, in practice a number of factors complicate
the implementation of the Bagehot’s principles:
• In the midst of a crisis, information about the
degree of solvency is not readily available. Perfect
information does not exist, neither is it easy to
distinguish between “good” and “bad” collateral in
the case of an insolvent bank.
• To avoid systemic implications, the authorities
have a tendency to bail out insolvent “systemically
important” institutions to prevent the failure or
even collapse of the financial system (called the
“too-big-to-fail” argument).
• Even if part of the banking system is allowed to
fail, the authorities may find that it becomes far
more difficult to achieve their macroeconomic
objectives (including price stability, financial
stability and fiscal stability), owing in part to a loss
of confidence and the unavailability of alternate
funding, which alter the private sector’s behaviour.
• Banks find it difficult to redeem LOLR loans, and
the penalty rates imposed by the central bank
impact negatively on their solvency.
All these factors can interact and worsen a crisis and
complicate crisis management. In essence the more
imperfect the information and the greater the premium
placed by politicians on a rapid solution to a financial
crisis, the greater is the moral hazard for the central
bank. Considering the high and costly information
requirements, it is doubtful whether central banks can
always justify their LOLR assistance, as their
intervention costs may well exceed the benefits. There
are two broad approaches to addressing this problem:
(i) the “market-operation” approach which wants to do
away with LOLR assistance; and (ii) the “banking
policy” approach which aims to refine current LOLR
operations.
(ii) The market-operation approach
According to this approach, the central bank should
108
only provide liquidity to the market and focus
exclusively on providing liquidity to the system
against well-defined collateral (e.g. government
securities). Accordingly, the central bank should
supply emergency liquidity to the financial markets
(not individual institutions) through its open-market
operations, with government securities as underlying
assets. Under this approach the allocation of liquidity
is left to market participants. In essence, this school of
thought believes that the costs of LOLR assistance28
are greater than the benefits and that central banks
should therefore only be involved in monetary
stability. Moreover, it (conveniently) assumes that
financial stability would naturally follow monetary
stability. In fact the market-operation approach does
not address systemic or contagion risks. It usually
considers large insolvent financial institutions as being
“too big to rescue”, rather than “too big to fail”.
In many respect the ECB framework reflects the
market-operation approach as the Bank has a “narrow”
monetary stability mandate; has no mandate as a
LOLR; can only smooth interest rate movements by
using open-market operations; and may provide
liquidity only against penalty rates and against strictly
defined collateral (the Lombard facility).29 As a result
of these restrictions the ECB, like the Bundesbank in
the past, has to rely heavily on either Treasury or
private-sector support. However, Treasury standby
arrangements have the disadvantages that their
resources (i.e. the emergency liquidity funds) have a
limit and a sizeable opportunity cost, and that the use
of these funds requires parliamentary approval which
may be a time-inconsistent emergency solution.
Likewise, private-sector support – e.g. in the form of
deposit-insurance schemes, German-style liquidity
28
These costs include the cost of supervision and regulation; the
moral hazard cost flowing from imperfect information; the cost
of reduced peer monitoring among market participants owing to
the central banks’ LOLR role; and the cost of potential monetary
policy errors.
29
Another example of the use of the market-operation approach
was the general, unrestricted assistance given by the Fed to banks
at the discount window during the 1987 stock market crash to
avoid gridlock in the US payments system.
Financial Regulation in South Africa: Chapter 5
consortia or pools of solvent banks – may be time-
inconsistent during a financial crisis.
(iii) The banking-policy approach
This approach favours a more interventionist
financial stability role for central banks, on the
assumption that there is a strong relationship between
achieving and maintaining monetary and financial
stability. Four arguments are usually advanced to
support this approach:
• Market failures may preclude the fast and reliable
channelling of liquidity to illiquid, solvent
institutions.
• Widespread failures of financial institutions could
affect the confidence and the behaviour of the
private sector.
• Central banks can reasonably contain the moral
hazard implications by following the practice of
“constructive ambiguity”.
• Central banks are likely to be involved in most
banking crises (including insolvent institutions),
because they are generally the only source of
immediate (not necessarily ultimate) funds.30
The banking-policy approach is favoured by
institutions such as the US Federal Reserve and the
Bank of England both of which have, for instance,
considerable leeway in selecting eligible collateral and
counterparties. They may even make loans available at
a subsidised rate. On balance the banking-policy
approach rests on two assumptions:
• Central banks are in a better position to assess the
solvency of illiquid institutions than the market is31.
• Central banks contribute to an orderly resolution of
such crises with a limited and tolerable impact on
moral hazard and monetary (price) stability.
(iv) Rules versus discretion
Speed is increasingly becoming a critical factor in the
handling of financial crises. Firm rules, worked out ex
30
If the central bank is the immediate provider of liquidity for
LOLR operations and the Treasury the ultimate provider of
funds, then in practice the central bank needs Treasury
guarantees on LOLR operations.
31
At least in a crisis situation in which there is the potential for far-
reaching systemic implications.
Financial Regulation in South Africa: Chapter 5
ante on how to operate during distress periods,
improve speedy solutions. The regulatory arrangement
of LOLR should therefore be evaluated in particular
against its time-consistency. From the point of view of
speed, the central bank has major advantages over
private sector LOLR arrangements or Treasury
assistance. Indeed, the private sector is less likely to
consider the social cost of financial distress and
instead concentrate more on direct costs to private-
sector participants, which is likely to result in very
slow payouts (e.g. deposit-insurance schemes are slow
providers of liquidity assistance). Likewise, the
Treasury is bound to be slow with its assistance, as it
first has to obtain parliamentary approval.
Only the central bank is an immediate provider of
liquidity when required and its key role in financial
distress management seems natural if speed is of
the essence. However, even if the central bank
accepts its role as LOLR, the following arguments
should be considered:
• If obtaining perfect information in the shortest
possible time is aimed at during a banking
crisis, it is probably better that the bank
supervision function should be an integral part
of the central bank.
• If financial distress and systemic risks flow
primarily from large financial conglomerates, it is
better that bank supervision should be part of a
larger supervisory body. The supervision of
complex groups is increasingly a task for an
integrated supervisory agency, implying that bank
supervision should be outside the central bank and
be integrated with inter alia securities and
insurance supervision.
• If supervision is performed by an integrated
supervisory body outside the central bank, it
becomes crucial that an adequate and reliable
Memorandum of Understanding (MoU) should be
signed between the central bank and the
supervisory agency.
• If ultimate funds for LOLR are recovered by the
central bank from the Treasury, again a MoU would
have to be in place ex ante to the financial crisis.
109
• If the approach of MoUs between the three key
institutions (central bank, supervisors and
Treasury) proves in practice too complicated and
too slow to allow for a rapid assessment of the
systemic implications of a crisis, then the second-
best solution would probably be to have bank
supervision remaining part of the central bank,
although this solution seems suboptimal.
• If the central bank uses “constructive ambiguity” to
reduce its moral hazard in LOLR operations,
prudence would require, nevertheless, that there
should be no ambiguity among policy makers
about the mechanisms that can be used to manage
crisis situations.
In a nutshell, the sharing-of-information provisions
between the central bank and the supervisory agency
are crucial in an efficient and effective LOLR
operation.32 The aim of MoUs is to create a more
rules-based approach to LOLR operations, without
which co-operation between the central bank, the
supervisors and the Treasury would be difficult to
achieve.
Deposit-insurance scheme
The lender-of-last-resort facility is not an alternative to
deposit insurance. Deposit insurance should only be
activated after the bank has become insolvent. The
ultimate aim of deposit insurance is to facilitate the
liquidation of insolvent banks without the need for
bailouts and to contribute to the stability of the financial
system (e.g. by avoiding runs on banks). It does so by
quickly paying the many small and unsophisticated
depositors. This means that depositors are shielded from
the costs associated with bank insolvency.
To improve the deposit-insurance scheme and to
limit the moral hazard, the following are essential:
• The level of insurance cover must be relatively low
and clearly specified so that bank depositors and
32
For example in the UK the MoU between the Bank of England
and the FSA (paragraph 9) stipulates that: “the FSA and the
Bank will establish information sharing arrangements, to ensure
that all information which is or may be relevant to the discharge
of their respective responsibilities will be shared fully and
freely. Each will seek to provide the other with the relevant
information as requested”.
110
other creditors can be in no doubt about the insured
or uninsured status of their claims.
• In order to sustain depositor confidence in the
guarantee fund, compensation must be available
quickly.
• Participation in the deposit-insurance scheme for
banks should be mandatory, to avoid adverse
selection.
• The uninsured deposits and other liabilities should
be “credibly uninsured”. There should be no false
hopes of official support in the event of a bank’s
insolvency.
• The insurance premium should be market-related,
and thus risk-related. The risk premium on credibly
uninsured subordinated debt could be used as an
indicator to determine a market-related insurance
premium, provided the bond market is sufficiently
efficient and effective. Unfortunately, bond
markets are normally not so efficient, and this
limits the practical use of yields on unsecured
subordinated bank debts as a regulatory instrument.
• The insurance scheme should be funded ex-ante
rather than ex-post.
• Some form of co-insurance (i.e. depositors are
expected to share a portion of the losses within the
coverage limits) is recommended.
• If a bank fails, shareholders, managers and
unsecured creditors should lose, not taxpayers.
• The deposit-insurance scheme must insist on a
strong institutional infrastructure (e.g. accounting,
disclosure, compliance and corporate governance
standards).
As an ill-designed deposit-insurance scheme can do
more harm than good, the authorities should be careful
about practical implementation.33
The lifeboat facility and exit policy
As a financial institution in distress drifts (often not so
slowly) from being illiquid to insolvent, the operations
of the central bank may shift from LOLR to lifeboat
33
The relationship between the curatorship function and deposit
insurance could also be emphasised. For instance, in South
Africa the curator can freeze the deposits in a failed bank and
thus prevent bank runs.
Financial Regulation in South Africa: Chapter 5
operations (i.e. the financial institution is kept afloat)
and ultimately to exit policies (i.e. the institution is
scuttled). The ultimate aim of an exit policy is to
ensure that shareholders, managers and unsecured
creditors (particularly subordinated debt holders), but
not taxpayers, will pay for the failure. If the social cost
of failure exceeds the private cost of a bankruptcy,
Treasury emergency funds could justifiably be used,
but the government may then decide to nationalise the
financial institution and to resell it during better times.
This policy was followed in Scandinavia, when the
Government of Sweden, for instance, nationalised
most of the country’s big banks during the 1990–92
financial crises. The average costs, in the form of
guarantees and capital injections from the budget,
amounted to 5,9 percent of GDP. This cost was totally
recovered by the Swedish Government on the sale of
the appreciated shares of the now-profitable state-
owned bank (i.e. Nordbanken) in 1994–1996.
An alternative to nationalisation is ensuring that the
exit of failed financial institutions takes place through
the market process. This implies that a rules-based exit
policy is in place prior to a financial crisis. Generally a
rule-based exit policy guarantees the prompt and
orderly closure of insolvent institutions and ensures
that at least part of a bank failure is borne by owners/
shareholders, managers and perhaps creditors.
One mechanism to make this operational is through
the SEIR proposals (Structured Early Intervention and
Resolution) first suggested by academics in the United
States. Under this regime it is outlined in advance what
official intervention action will be triggered as and when
a bank’s financial position deteriorates beyond specified
levels. The United States and Japan are examples of
where rules require supervisors to take prompt action
when an institution’s capital ratio falls below a specified
level. A more radical example is the market-based
regulation in New Zealand (1996) that requires banks to
disclose publicly information that in other countries is
normally viewed as the “proprietary” information of the
authorities. The objective of the reforms is to limit
regulatory forbearance by passing some of the
responsibility for supervising the banking system to the
Financial Regulation in South Africa: Chapter 5
markets, and to reduce moral hazard by changing the
incentives of bank managers. Together with full
disclosure, these reforms increase the frequency of
external audits and credit ratings, eliminate official
deposit insurance, and make financial institutions’
managers personally liable and accountable.
Once the rules of the exit policy have been
announced, the authorities have to credibly commit
themselves to such rules. The worst possible scenario
would be where the government announced its intention
not to provide emergency credit assistance in the future,
but the banks believed that in fact it would. In this case,
if a liquidity problem arose, banks would not have
prepared for it by holding sufficient capital and by
arranging lines of credit. If the government remained
true to its policy, widespread insolvency could prevail.
Ultimately the exit policy of the authorities for failed
financial institutions is only one particular instrument
in an array of policy instruments available on how to
restructure systemically the financial, and more
specifically, the banking industry. As is evident from
Table 5.2, the restructuring tools available to the
regulatory authorities embrace structural and financial
measures, with the closure of failed banks being only
one of the structural possibilities. In practice, the
authorities use an average of about eight different
instruments to address the issue of systemic bank
restructuring.34 Successful reform requires, as a first
step, that solvency should be restored. This is usually
the easy part of the restructuring programme; far more
difficult is the restoring of sustainable profitability,
which always means that management deficiencies
have to be addressed promptly and head-on. Achieving
profitability without exception requires painful
operational restructuring, which is not only difficult
but also time-consuming (generally, the central bank
can be supportive but not operationally involved). For
this reason alone, the authorities should ideally
anticipate the need for reforms and carry them out in
times of relative financial calm.
34
Dziobek, C. and C. Pazarbasioglu, “Lessons from Systemic Bank
Restructuring”, Economic Issues, No. 14, Washington:
International Monetary Fund, p. 4.
111
3.6 Recent trends in regulatory practice
Space precludes a detailed review of how regulatory
arrangements have been evolving. However, in some
areas substantial changes have been made and others
are in the pipeline. This section briefly considers some
of the trends that are emerging with respect to the
international approach to the prudential regulation and
supervision of banks.
When setting capital-adequacy standards on banks,
the regulator confronts a negative trade-off between
the efficiency and costs of financial intermediation on
the one hand, and financial stability on the other.
Although it is a complex calculation – absent the
Modigliani-Miller theorem (which does not, in any
case, apply to banks with deposit insurance) – as the
cost of equity exceeds the cost of debt (deposits) the
total cost of financial intermediation (measured, for
instance, by the banks’ interest margin) rises as the
equity-assets ratio rises. If the regulator imposes an
unnecessarily high capital ratio (in the sense that it
exceeds what is warranted by the risk profile of the
bank), an avoidable cost is imposed on society through
a high cost of financial intermediation. On the other
hand, a high capital ratio reduces the probability of
bank failure and hence the social costs of financial
instability. It also means that a higher proportion of the
costs of a bank failure are borne by specialist risk
takers rather than depositors.
This means that regulatory capital requirements can
either be too high or too low and both involve costs.
If capital-adequacy requirements are set too high
three potential costs arise: the cost of financial
Table 5.2: Tools available for systemic bank restructuring
Structural measures
• Central bank as sole restructuring agency
• Central bank liquidity support
• Loan workout units (public- or bank-based)
• Closure of insolvent banks
• Merger of insolvent banks
• Privatisation (where applicable)
• Enterprise restructuring to improve creditors
• Twinning with foreign banks
112
intermediation becomes excessive; regulation imposes
an unnecessary tax on banks with the result that
financial intermediation business may switch to
unregulated firms; and banks may respond by seeking
to cover the higher costs through more risky business
with a higher expected rate of return. On the other
hand, if capital ratios are set too low the cost of
financial instability is likely to rise. Because of this
trade-off, unnecessary costs are imposed if regulatory
capital (capital-adequacy requirements imposed by
regulation) is not aligned with economic capital (what
is needed on the basis of actuarial calculations of a
bank’s risk).
When judging the efficiency and effectiveness of
capital-adequacy regulation, four basic criteria should
be applied:
• Does it bring regulatory capital into line with
economic capital?
• Does it create the correct risk-management
incentives for owners and managers of banks?
• Does it produce the correct internal allocation of
capital as between alternative risk assets and
therefore the correct pricing of risk?
• To what extent does it create moral hazard?
BIS approach to capital adequacy
It is well established that there are many problems
with the current BIS capital-adequacy regime (1988
Accord). In particular:
• The risk weights applied to different assets and
contingent liabilities are not based on actuarial
calculations of absolute and relative risk. This in turn
creates incentives for banks to misallocate the
Financial measures
• Bonds (e.g. in exchange for bad loans)
• New equity (e.g. bought by government)
• Depositor-based instruments
• Owners, management, market incentives
Financial Regulation in South Africa: Chapter 5
 internal distribution of capital and to choose an
uneconomic structure of assets. It is also liable to
produce a mis-pricing of risks. There is, for instance,
an incentive to choose assets whose regulatory risk
weights are low relative to the economic (true) risk
weights even though, in absolute terms, the risk
weights may be higher than on alternative assets.
The distortion arises not because of the differences
in risk weights but to the extent that differentials
between regulatory and economic risk weights vary
across different asset classes.
• The methodology involves the summing of risk
assets and does not take into account the extent to
which assets and risks are efficiently diversified.
• No allowance is made for risk-mitigating factors
such as hedging strategies within the bank.
• All loans carry a risk weight of unity whereas the
major differences within a bank’s overall portfolio
exist within the loan book.
• Banks are able to arbitrage their regulatory capital
requirements in a way that lowers capital costs
without any corresponding reduction is risk.
• The current Basel Accord only applies to credit and
market risk.
Although national regulatory and supervisory
authorities have discretion about how the Accord is to
be applied (subject to certain minima), and therefore
the distortions may not be as serious in practice as the
Accord might suggest, the fact remains that the Accord
is seriously flawed.
Partly because of these weaknesses, the Basel
Committee on Banking Supervision has recently
proposed a new framework for setting capital-
adequacy requirements, (Basel Committee, 1999). It
has issued a substantial consultation document which,
if adopted, would represent a significant shift in the
approach to bank regulation. This is not discussed in
detail here other than to note that it is based on three
pillars: minimum capital requirements, the supervisory
review process and market discipline requirements.
The proposed new approach can be viewed in terms of
the regulatory regime paradigm:
• Substantial emphasis is to be given to the importance
Financial Regulation in South Africa: Chapter 5
of banks developing their own risk analysis,
management and control systems, and it is envisaged
that incentives will be strengthened for this.
• The Committee’s consultative paper stresses the
important role of supervision in the overall
regulatory process. This second pillar of the
capital-adequacy framework will: “seek to ensure
that a bank’s capital position is consistent with its
overall risk profile and strategy and, as such, will
encourage early supervisory intervention”.
• In an attempt to bring regulatory capital more into
alignment with economic capital, it is proposed to
widen the range of risk weights and to introduce
weights greater than unity.
• A wider range of risks is to be covered including
operational risk.
• Capital requirements are to take into account the
volatility of risks and the extent to which risks are
diversified.
• Although a modified form of the current Accord
will remain as the “standardised” approach, the
Committee believes that for some sophisticated
banks, use of internal and external credit ratings
should be incorporated, and also that portfolio
models of risk could contribute towards aligning
economic and regulatory capital requirements. The
Committee recognises that use of internal ratings is
likely to incorporate information about customers
that is not available either to regulators or external
rating agencies. In effect, in some respect this
would involve asking banks themselves what they
believe their capital should be. This is a form of
precommitment. The object is to bring the
regulatory process more into line with the way
banks undertake risk assessment.
• A major aspect of the proposed new approach is to
ask banks what they judge their capital should be.
Any use of internal ratings would be subject to
supervisor approval – this is an element of, what
earlier was termed, contract regulation.
• Allowance is to be made for risk-mitigating
factors.
• Greater emphasis is to be given to the role of
113
 market discipline. The third pillar in the proposed
new approach is market discipline. It will
encourage high standards of transparency and
disclosure standards and “enhance the role of
market participants in encouraging banks to hold
adequate capital”. It is envisaged that market
discipline should play a greater role in the
monitoring of banks and the creation of
appropriate incentives. The Committee has
recognised that supervisors have a strong interest
in facilitating effective market discipline as a
lever to strengthen the safety and soundness of the
banking system. It argues: “market discipline has
the potential to reinforce capital regulation and
other supervisory efforts to promote safety and
soundness in banks and financial systems. Market
discipline imposes strong incentives on banks to
conduct their business in a safe, sound and
efficient manner”.
• The proposals also include the possibility of
external credit assessments in determining risk
weights for some types of bank assets. This would
enhance the role of external rating agencies in the
regulatory process. The Committee also suggest
there could usefully be greater use of the
assessment by credit rating agencies with respect to
asset securitisations made by banks.
• The consultation document gives some emphasis to
the important role that shareholders have in
monitoring and controlling banks.
Overall, the new approach being proposed
envisages more differentiation between banks, a less
formal reliance on prescriptive rules, elements of
choice for regulated institutions, elements of
contract regulation, an enhanced role for market
discipline, a greater focus on risk analysis and
management systems, some degree of
precommitment, and a recognition that incentives for
prudential behaviour have an important role in the
overall approach to regulation.
3.7 Summary
To ensure good governance in finance regulation and to
114
improve the efficiency and effectiveness of supervisors,
three key building blocks have to be in place.35
Proper incentives
These incentives have to ensure that the following are
in place:
• Bank insiders should have a significant equity
stake in the banking business.
• Banks’ accounting policies need to reflect market
risks and borrowers’ credit risks.
• Bank directors need to be accountable.
• Connected lending and ownership of banks by
commercial interests need to be prohibited or
tightly controlled.
• A limited and explicit role for public deposit
insurance.
• Protection of the interests of minority shareholders,
especially among banks that are closely held.
• A duty of loyalty should be imposed on controlling
shareholders who also serve as bank directors.
• Independent directors and the use of audit
committees to deter insider abuse.
• The interests of banking supervisors should be
aligned with those of taxpayers.
Ensuring transparency
Usually the coverage and standards of banks’
disclosure leave too much scope for discretion. In
order to ensure proper transparency, the following
information should be disclosed:
• Besides the normal financial statements, banks should
publish their capital-adequacy ratio, peak exposure
concentration, lending to related parties and to
members of the board, and any conflicts of interest.
• Disclosure should follow marked-to-market
procedures and thus reflect the effects of exchange
rates, interests rates and commodity prices.
• Bank directors should attest that their disclosures
are not false or misleading.
• Banking information should be given to the
markets to a greater extent, rather than exclusively
to the authorities. The aim should be for market-
35
Leechor, C., “Banking on Governance?”, Public Policy for the
Private Sector, The World Bank Group, Washington, December
1999, pp. 45–48.
Financial Regulation in South Africa: Chapter 5
 based disclosure on a quarterly basis, informing
depositors, their agents and outside shareholders.
• Likewise, banking supervisors should be more
transparent. They should be required to disclose
regulatory opinions on official forbearance or
corrective actions.
• The authorities should disclose the risk exposure of
public guarantee funds.
• Supervisors, like directors, should be requested to
attest that their disclosures are not false or
misleading.
Clarifying accountability
Along with better disclosure, competition in the
banking business can make bankers more accountable.
The following points arise:
• To attract funds, banks would have to rely more on
investment merits, including good governance and
creditworthiness.
• There should be adequate sanctions against abusive
practices, particularly for a breach of rules of
disclosure.
• Bank insiders should have unlimited liability for
abusive practices.
• Minority shareholders and taxpayers should have
access to judicial remedies against insider abuse.
Financial Regulation in South Africa: Chapter 5
• Banking supervisors should have clearly defined
performance criteria and a governing body
accountable to the taxpayers.
• Supervisors should set targets for the risk exposure
of public funds, explain any deviations from the
targets and provide a clear plan of corrective actions.
• Supervisors, like directors, should face significant
sanctions for breach of duty.
• A regulatory audit agency could help in
investigating official misconduct.
• An independent and aggressive media can play a
critical role in the enforcement of supervisory
standards.
All of this amounts to a rebalancing between the
different components of the regulatory regime and, in
particular, greater emphasis should be given to
effective supervision by official agencies; a clearer
focus on the incentive structures faced by all
stakeholders in regulation; an enhanced role for market
discipline; effective corporate governance
arrangements in banks; clearly defined and credible
rules for the intervention in the case of deteriorating
banks; and proper accountability of regulatory and
supervisory agencies.
115
 Chapter 6
THE CURRENT REGULATORY STRUCTURE OF
THE SOUTH AFRICAN FINANCIAL SYSTEM IN
THE INTERNATIONAL CONTEXT
This chapter endeavours to describe the current
structural framework of financial regulation in South
Africa. Any financial system consists of three major
components: (i) financial instruments; (ii) markets in
which these instruments trade; and (iii) market
participants1. This analysis is divided into similar
sections. Section 1 examines the current regulation of
financial instruments. Section 2 outlines the regulation
of financial markets and Section 3 analyses the
regulation of financial market participants. In each
section the regulatory regime is highlighted by means
of a regulatory matrix.
1. Regulation of financial
instruments
1.1 The definition and nature of
financial instruments
Ultimately any financial instrument can be broken
down into cash (money) and/or options. Therefore
cash and options provide the basic building blocks for
“financial engineering”, which facilitates the
continuous creation of new financial instruments.
Simultaneously, competition ensures the demise of
commercially unviable instruments. In fact, not all
newly created financial instruments survive in the
long run, as some new instruments are often not
liquid enough, too complicated, too difficult to
capture in existing management control systems, or
simply have fulfilled their tasks. Diagram 6.1 gives
an overview of major financial instruments in the spot
and derivative markets.
1 2
Such as lenders, borrowers, financial intermediaries, brokers,
fund managers, financial advisers and trustees.
116
1.2 The regulatory regime and structure
for financial instruments
Since financial innovation enhances competition, the
regulatory authorities are reluctant to interfere
unnecessarily in the creation of new instruments, some
of which can be used to mitigate risk. The issuing of
and trading in many financial instruments are therefore
subjected by and large to market disciplines only. For
instance, swap contracts – despite their large amounts
and often sophisticated nature – are unconstrained in
terms of official regulation2 in South Africa.
In contrast, the authorities do regulate the issue of
company shares and debt instruments, as well as the
derivatives on these instruments. For instance, in the
interests of systemic stability the authorities prescribe
minimum standard requirements for the issuing of
money- and capital-market instruments and/or the way
they should be traded.
The issuing of money- and capital-market instruments
is regulated by general legislation, specific prescriptive
legislation and/or specific enabling legislation. Those
money- and capital-market instruments can be created
by a wide variety of issuers and are usually regulated in
terms of general legislation. For instance, the Bills of
Exchange Act and the Companies Act stipulate in detail
the issuing and processing requirements of bankers’
acceptances, trade bills, promissory notes, corporate
debentures and equities.
In cases where the issuer is established in terms of
specific prescriptive legislation (e.g. in the case of a
public business enterprise) such legislation usually
contains stipulations about the issuing requirements
The market may however constrain trading operations by
applying self-imposed regulation.
Financial Regulation in South Africa: Chapter 6
and processing of the relevant instruments. For
example, the Exchequer Act controls the issuance of
Treasury bills and government bonds, the South
African Reserve Bank Act the issuance of SARB
debentures, the Banks Act the issuance of NCDs, the
Land Bank Act the issuance of Land Bank bills and
Land Bank debentures, whereas the acts establishing
various public corporations and local authorities
regulate the issuance of public corporation and local
authority bonds.
Fiduciary money is also a financial instrument, as it
represents a claim on the government3. The issuance of
coin and banknotes is regulated in terms of the South
African Reserve Bank Act. The issuance of foreign
exchange vests of course in foreign authorities, but
trade in such currencies within the South African
jurisdiction is subjected to strict regulation by the
exchange control authorities.
In South Africa the financial and commodities
exchanges (i.e. formalised investment markets) are
regulated in terms of enabling legislation. The Stock
Exchanges Control Act regulates the operations of the
3 original liability and substituting a new liability in its place.
In low-inflation countries government income flowing from
seignorage is some 2–3% of government revenue, but in high-
inflation countries it may be over 10% of government revenue
(see BIS, Policy Papers No. 1, 1996).
Diagram 6.1: Types of financial instruments
Cash
Financial instruments
Spot market instruments
(spot settlement)*
Currencies Equities
Debt
* “Spot” settlement in South Africa is currently 2 days (T+2) in the currency market, 3 days (T+3) in the bond market and up to 7 days in the equity market.
Financial Regulation in South Africa: Chapter 6
Johannesburg Stock Exchange4 (JSE), and the
Financial Markets Control Act regulates the activities
of the Bond Exchange of South Africa (BESA) and the
South African Futures Exchange (SAFEX). These
exchanges not only supervise trade in financial
instruments – such as listed equities and corporate
debentures and options5 on these (JSE); bonds and
options on bonds6 (BESA); and futures and options
contracts on these futures (SAFEX) – but also
prescribe minimum listing requirements for these
instruments. In this way the issuance of equities,
debentures and bonds is regulated by both general and
specific legislation. In the case of futures and option
contracts, an exchange can even act as the creator of
these derivative financial instruments. For instance,
SAFEX places itself as a “middleman” in every trade,7
4
Now named the JSE Securities Exchange.
5
An option on an individual share is also called a warrant. Today
the JSE’s trade in derivatives is de facto limited to warrants.
6
Although the BESA is permitted to regulate bond options, most
of the bond derivative market in South Africa is over-the-
counter (i.e. not formalised).
7
The process involved here is novation, i.e. where two parties to a
contract agree to enter into a new contract putting an end to an
Novation takes three forms: i) extinguishing an existing debt and
substituting a new debt in its place; ii) substituting a new debtor;
and iii) substituting a new creditor.
Options
Derivative market instruments
(forward settlement)
Forward contracts Option contracts
Futures contracts Other derivative contracts
117
i.e. the exchange is either a buyer or seller of futures
and option contracts with all its clients.
As reflected in the regulatory matrix (see Table 6.1),
financial instruments as such are fairly leniently
regulated in South Africa. In essence the regulatory
authorities only want to ensure that the rights and
obligations represented by those instruments (e.g. the
underlying credit soundness) are secure. It is instead
the financial markets or the users of financial
instruments who are regulated. The major statutory
constraints applicable to the issuance of financial
instruments are the following:
• Minimum quality standards: Usually when new
financial instruments are created they are relatively
free of quality requirements. However, over time
there is a tendency to standardise, if only to
improve the liquidity of such instruments. For
example, one important reason for the
standardisation of forward contracts into futures
contracts is the higher degree of market liquidity
that goes hand in hand with such standardisation. A
second reason for standardisation is to regulate
minimum quality standards (e.g. in respect of
disclosure and fairness) as set by the authorities
and/or the exchange. For example the issue of
equities is constrained by the Companies Act and
the listing requirements of the JSE.
• Operational constraints: Financial instruments
may not be misleading, neither should their
issuance result in conflicts of interest. The pricing
of financial instruments should be transparent and
fair. Accordingly, the issuance of corporate
debentures requires the issuing of a prospectus
with detailed disclosure requirements.
• Market monitoring and discipline: Competitive
forces ensure that only the most effective and cost-
efficient financial instruments survive over time.
The stability of financial markets is enhanced by
the elimination of those instruments that either lack
a sufficient degree of liquidity or that are not
(globally) competitive. Besides the legal minimum
standards and operational constraints placed on the
issue of instruments, the market itself effectively
118
ensures the quality of financial instruments. This
market discipline in turn promotes integrity and
transparency to an even higher extent than often
can be enforced by the regulatory authorities.
Diagram 6.2 gives a structural overview of how
financial instruments are regulated in South Africa. As
noted, financial instruments issued and/or traded
outside the equities, bond and futures markets are
usually subjected to market discipline and market-
monitoring mechanisms only. For instance, option
contracts written in the informal market (e.g. on
residential property) are unregulated. Likewise most
products of financial engineering (usually complex
off-balance-sheet instruments) are unregulated at the
time of their creation.
2. Regulation of financial markets
The regulation of financial markets is more
complicated than that of instruments owing inter alia
to the complex nature of markets. For instance,
markets can: trade in one or more basic financial
instruments; be of an informal or formal nature;
embrace spot and/or derivative instruments; be
subdivided into various smaller market segments each
with its own character (e.g. primary issue and
secondary trading markets); and be regulated by one or
more regulatory authorities. Moreover, financial
markets show a high degree of interdependence. These
issues will be addressed in this section under the
following headings:
• Difficulties in defining a financial market
• The nature of over-the-counter and regulated
markets
• The instruments traded on financial markets
• The aggregation of financial instruments into basic
markets
• Types of financial markets and their regulation
• The regulatory regime and structure of financial
markets
2.1 Difficulties in defining a financial
market
So long as a financial market trades in only one
Financial Regulation in South Africa: Chapter 6
 Table 6.1: Regulatory matrix: Financial instruments
Institutional safety and
Regulatory ultimate objectives Systemic stability Consumer protection
soundness

Regulatory
intermediate goals

liquidity
fairness
schemes

neutrality
disclosure

Proper risk
retail funds

assessment
Competitive
Integrity and
Competence
Protection of

infrastructure
infrastructure
Fit and proper
Access to retail

competitiveness
competitiveness

Financial Regulation in South Africa: Chapter 6

Sufficient market
financial services

market exposures
Acceptable cross-
Transparency and

directors and staff

Global institutional

Proper institutional

Competitive market
Retail compensation

currency mismatches
Securities markets as
Regulatory regime and

efficiency and economy

Acceptable maturity and

Regulatory effectiveness,
Adequate product/service

its instruments

alternative to intermediation
1. Official rules and regulations
1.1 Entry and standards constraints X X X X

1.2 Ownership constraints

1.3 Functional activity constraints
1.4 Jurisdictional constraints
1.5 Pricing constraints
1.6 Operational constraints X X

2 Official monitoring and supervision

3. Intervention and sanctions

4. Incentive contracts and structures

5. Market monitoring and discipline X X X X X

6. Corporate governance

7. Discipline/accountability of
regulators

119
specific financial instrument, it can usually be defined
in terms of the instrument being traded. For instance,
the bond market can be defined as a place or facility8
where trade in bonds takes place. However, the
grouping of different types of financial instruments into
a single financial market usually results in problems of
definition. A few examples illustrate this point.
The money market is usually defined as the spot
market for short-term “securities”9. But what is short
term? For some dealers the demarcation between the
money market and bond market in South Africa is
three years because, they argue, it is only then that
8
It used to be a trading floor, but today most financial markets are
electronic. Bond markets have generally been the last to embrace
electronic trading technology, with corporate bond markets being
last of all.
9
Securities may be notional or fictitious.
bonds obtain their statutory liquid-asset status.
However, most dealers, both in South Africa and
abroad, define the money market as a market that
trades in instruments with a maximum tenor of only
one year.
Apart from the issue of the tenor of money-market
instruments, there are some additional problems of
definition. The distinction between the spot market
and the forward market is unclear at times. It is
normal practice to consider some repurchase
agreements (e.g. valid for a few days only) as
money-market instruments, despite the fact that a
repurchase agreement is in essence a forward
agreement and therefore belongs to the forward
market. Even if participants aim at spot settlement in
the money market, this may not always be possible
because of problems related to market practices,

Diagram 6.2: Regulation of financial instruments

Legislation in respect of
financial instruments

General Specific prescriptive Specific enabling

legislation legislation legisltion

Companies Act Exchequer Act Financial Markets Control Act

Bills of Exchange Act SA Reserve Bank Act Stock Exchanges Control Act
Banks Act
Land Bank Act
Corporate debentures Enabling acts of: Exchanges:
Equities - Local authorities - BESA
Bankers’ acceptances - Public corporations - JSE
Trade Bills - SAFEX
Promissory notes
Coins and banknotes
Treasury bills Listed instruments:
Landbank bills - Debt/bonds
SARB debentures - Company debentures
Land Bank debentures - Equities
NCDs - Futures
Capital project bills - Options
Bridging bonds
Bonds:
- Local authorities
- Public corporations
- Government

120 Financial Regulation in South Africa: Chapter 6

clearing procedures and the physical delivery of
assets. Consequently the definition of the money
market as the spot market in short-term debt
instruments (tenor no longer than one year), with
settlement within one or two days, could be regarded
as being somewhat arbitrary.
The problems of definition do not end here, as a spot
position can be simulated either by buying the asset
outright (i.e. a long instrument) or by means of a
synthetic position (in this case a long call plus short
put both at the same strike price)10. Are synthetic spot
positions part of the spot market? For investors and
speculators the difference is often academic, as they
can make or lose as much money on an outright spot
position as on a synthetic spot position. However,
most money-market dealers see this issue in a different
light, regarding the spot market and derivative market
as two distinct markets.
Because markets are so difficult to define, it is
obviously also difficult to say where one market ends
and another begins. Until the early 1980s the
distinction between the forward and futures markets
was well understood and defined. Futures contracts
were seen as standardised forward contracts traded on
an exchange. However, this distinction has faded with
the rapid development of forward (or future) rate
agreements (called FRAs), which can be defined as
over-the-counter futures contracts. Banks in the major
financial centres of the world create very liquid
markets in FRAs, effectively operating as market
makers for such instruments. Moreover, two
traditional markets can easily merge into a new
market, creating new problems of definition. For
example, how to legislate (if that is desirable at all) for
a “swoption” market, which is a combination of the
activities of the traditional swap and options markets?
In conclusion, the concept “market” should be used
with care and circumspection, particularly in
10
Different instruments may be used to do the same thing, which
raises the question of whether regulation should focus on
function or instrument. The same issue arises between functions
and institutions when demarcations between institutions are
eroded.
Financial Regulation in South Africa: Chapter 6
legislation11. Accordingly, legislation mostly addresses
issues relating to the structure of a market, the types of
instruments traded in a market, the participants in such
a market and the activities taking place in the market.
Imposing a structure on the market – without actually
putting forward a concise definition of the market
concerned – therefore effectively dispenses with the
question of the definition of a market.
2.2 The nature of over-the-counter and
regulated markets
2.2.1 The over-the-counter (OTC) market
In any country most trade takes place in informal (or
over-the-counter) markets. Buyers and sellers meet
over a counter (e.g. shop or bank counter), in a
marketplace (e.g. flea market or trading floor), or via a
computer screen (e.g. most securities markets
nowadays). OTC markets may be totally free of
official supervision or be subject to regulation imposed
by the authorities in terms of general legislation only
(e.g. the licensing of trade). Most new financial
markets start as OTC markets, and some develop into
regulated markets with the passage of time.
2.2.2 The regulated market
Regulated markets (or exchanges) are governed by
specific enabling legislation as well as the rules of self-
regulatory organisations (SROs), which are established
in terms of this legislation. Exchanges usually specialise
in only a limited range of products (e.g. bonds, equities
or futures), and make specific allowance for trading with
small, retail investors. Trading on an exchange has to
take place in accordance with the exchange’s rules,
which are aimed at reducing the financial risks of
executing on-market transactions (i.e. risks relating to
11
The difficulty in correctly applying the terms “market” and
“exchange” is illustrated in the Financial Markets Control Act
1989, where, for example, an exchange is required to apply for a
financial market licence prior to undertaking business. However,
the financial market itself (comprising buyers and sellers of
financial instruments) exists independently of the exchange and
would continue to operate in the absence of a formal regulated
structure.
121
counterparty, open positions, large exposures and
settlement). This emphasis on risk reduction also extends
to the minimisation of undesirable practices such as
front-running, insider trading and price manipulation.
2.2.3 Some differences between OTC and
regulated markets
As regards the type of product or the type of market
participant, OTC markets and regulated markets differ
in four major respects:
• Not every kind of merchandise can be listed,
because standardisation, as required for dealing on
an exchange, is possible only in the case of a
limited number of products. OTC trading will
therefore always constitute a very large and
important market segment.
• International markets (including offshore centres)
are usually OTC markets. For example the foreign-
exchange market or the eurobond markets are
running very efficiently as OTC markets and, being
of an international nature, difficult to regulate by one
national regulatory authority even if it wanted to.
• As explained in greater detail below, membership of a
regulated exchange is usually restricted in terms of a
rulebook, but in an OTC market entry is restricted by
conventions of the participants.
• Systemic risk is usually lower in a regulated
exchange than in the OTC market owing to
prudential requirements on members and
sophisticated clearing and settlement systems. For
instance, in an OTC market there is no formal
exchange to “stand good” for trade settlement,
whereas the participants in the formal market are
often subjected to “fit and proper” requirements
(such as examinations).
In short, an exchange is a formalised market
segment, which can never fully replace the OTC
market in all its targets.
2.2.4 The transformation of an OTC market
into a formal market
There is no specific economic need to transform OTC
markets – which are essentially wholesale markets –
122
into formal markets. OTC markets have great
flexibility and, with modern technology, they can
compete very effectively with formal markets. For
instance, markets such as the euro currency, swap,
forward and securitised-asset markets can easily
compete with any exchange in terms of liquidity and
trading sophistication. Moreover, most major financial
innovation takes place in the OTC markets, because
the formalisation of trade in specific new instruments
can occur only subsequent to their creation.
It seems that the transformation of an OTC market
into an exchange usually takes place for one or more
of the following reasons:
• The management of risk. The authorities may
regard the general legislation governing OTC
markets as insufficient from a risk management
point of view, and so supplement it by the rules
and regulations of an exchange. A very successful
OTC market may therefore eventually invite
regulation by the authorities, since the more
successful it becomes, the greater the consequences
of default (i.e. systemic failure) and therefore the
likelihood that the authorities will prescribe more
detailed risk-management procedures within the
framework of an exchange. The establishment of
the BESA is an example in this regard.
• Counterparty risk management. In contrast to OTC
markets where participants carry counterparty risk,
an exchange guarantees settlement (i.e. the
exchange stands good for the counterparty risk).
• The netting of trading positions. The partial
offsetting of long against short trading positions for
capital-adequacy purposes is usually only done if
the risk exposure is supervised by an exchange
which guarantees settlement12.
• The need for greater liquidity. Although an OTC
12
However, it should be borne in mind that several OTC markets have
adopted relatively sophisticated trading, margining and settlement
systems, often under the auspices of an industry association of some
sort e.g. the International Securities Markets Association. In the
United States, the Government Securities Clearing Co-operation
(GSCC) manages a sophisticated risk-management system for all
bond trades concluded in the OTC market. Netting of positions is
permitted and is a strong feature of the GSCC.
Financial Regulation in South Africa: Chapter 6
 market can be very liquid (e.g. the currencies
markets), this may not necessarily be the case. For
instance, establishing an exchange can often
increase liquidity in the equities markets, as this
facilitates participation by small investors who are
usually barred from the OTC markets. Generally, if
a market has a great potential for retailing, the
choice usually falls on a formal market structure,
though a typical wholesale market often prefers an
OTC market structure.
• The avoidance of monopolistic pricing. Fair
competition could be endangered if a few big
players in the OTC market were to acquire
oligopolistic powers. At stake here is the issue of
central price discovery. To avoid the underlying
market being squeezed, or even cornered by the use
of derivatives, the authorities may prescribe that all
trade in derivatives should be effected through a
formal derivative exchange.
Ultimately the way in which financial markets are
structured depends mainly on place and time, as their
structures are determined inter alia by the historical
development of a market, its custom, underlying market
liquidity and competitive forces. All of these may differ
materially between countries. In fact, international
evidence indicates that there are no hard and fast rules
for the organisational structure of a market.
Diagram 6.3: Listed and OTC spot-market instruments
Regulated exchange
Listed commodities Listed securities
Debt instruments
Financial Regulation in South Africa: Chapter 6
2.3 The instruments traded on
financial markets
2.3.1 Spot markets
In the spot market, exchanges concentrate on specific
securities which are approved by the particular
exchange for listing purposes (e.g. the Johannesburg
Stock Exchange trades mainly in equities). By
contrast, unlisted financial instruments (e.g.
currencies, shares in private companies, bankers’
acceptances) are traded in OTC markets. However,
even listed shares can be bought or sold away from an
exchange – for instance by “private treaty”. Although
there may be a formal market for a specific security,
buyers and sellers may not always wish to use such a
market. Particularly between large participants, private
treaty deals are attractive inter alia to avoid disclosure,
to trade at non-market related prices (i.e. transfer-
pricing techniques), or to save on commission
payments. Usually the authorities try to limit the off-
market trading of listed instruments. However, if such
a trade occurs, it is usually compulsory to disclose to
the exchanges the volume and prices of such off-
market trades13. Diagram 6.3 depicts the structure of
the spot market.
13
At present, off-market equity trades are not currently reported to
the JSE. However, on enactment of the Investment Services Act
this will become a requirement (probably in 2001).
Spot market
OTC market
Commodities Currencies
Debt instruments Equities
Equities
123
2.3.2 Derivative markets
The structure of the derivative instruments market is
analogous to that of the spot market (see Diagram 6.4).
Derivative instruments are “derived” from the basic
assets of spot markets (namely commodities, currencies,
equities and debt instruments). As with spot market
instruments, derivative instruments can be traded either
on an OTC basis (e.g. forward contracts) or on an
exchange (e.g. futures contracts). They differ from spot
market products primarily because the final settlement
of the contract is deferred to some future date.14
In a narrow conceptual sense, derivative instruments
(i.e. “instruments B terme”) embrace only forwards
and futures, though in a broader sense they also
include options (incorporating the concept of option
premiums with forward settlement). By volume, trade
in derivative instruments probably takes place mostly
in the OTC markets. Highly standardised securities
that are not traded on an exchange – such as a forward
rate agreement (FRA) – can be considered a hybrid
between instruments traded in the formal and OTC
markets. Abroad, the FRAs market is huge, which
indicates the capacity of OTC markets if supported by
powerful financial intermediaries.
2.3.3 The relationship between spot and
derivative markets
As noted previously, a spot market position can be
replicated by means of a synthetic position.15 This fact
implies that spot and derivative markets have the
potential to be in competition with one another.16
Depending on additional considerations such as

14 15
In the formal futures markets, cash settlement takes place daily For example, a short spot position by way of a long put and short
on a marked-to-market basis (i.e. the “margin call”) until the call, both at the same strike price.
contract finally matures at some future date. 16
This is the crux of the Arrow/Debreu contingent claim analysis.

Diagram 6.4: Listed and OTC derivative market instruments

Derivative market

Regulated exchange OTC market

(standardised with clearing) (customised without clearing)

Listed option contracts Futures contracts Forward contracts OTC option contracts

yyyyyyyy
Derivative market instruments in the narrow sense*

Derivative market instruments

Co in the broadiiimmiodities
sense

Commodities Financial assets

Currencies Debt instruments Equities

* Derivative instruments used here as a translation for instruments à terme

124 Financial Regulation in South Africa: Chapter 6

taxation, market liquidity, brokerage and transactions
costs as well as voting rights (e.g. a synthetic equity
position does not grant voting rights, as does an
outright spot position), the investor may prefer either a
spot or a synthetic position.
Although competition among exchanges is desirable
from a cost-efficiency point of view, it could
nevertheless impair systemic risk management.
Competing exchanges may harm one another, for
example, through reduced liquidity (if both exchanges
were to trade slightly different products) and by
complicating risk-management procedures (a circuit
breaker applied on one exchange should immediately
be effective for another exchange trading that same or
similar products). Generally the authorities actively
supported the emerging derivatives exchanges during
the 1970s, although today competition among
exchanges is very much anchored in market discipline.
The authorities prefer to address the resulting
problems of market liquidity and systemic risks with
technological solutions such as fully automated trading
systems and linking the information flows among
exchanges. Anyhow, with the rapid development of
Internet stockbroking the authorities are forced more
or less to rely increasingly on market discipline,
market incentives as well as corporate governance
rules to ensure orderly markets.
2.4 The aggregation of financial
instruments into basic markets
The problem of determining which financial
instruments should logically be combined in one
financial market is more complicated than it may seem
at first glance. One criterion is to select common
characteristics. Another is to ask whether the product
can be replicated (or simulated) in another market. If
this is the case, the markets concerned should be
combined into a larger market. Based on this last-
mentioned criterion, only four basic markets can be
theoretically distinguished, namely:
• Commodities markets
• Currencies markets
• Equities markets
• Debt instruments markets
As in the case of the two basic building blocks of
financial engineering, namely cash and options, it is
possible to draw up a simple two-dimensional
classification matrix for these four basic markets.
This matrix, with the spot markets and options
markets on the two axes, is shown in Table 6.2
(where a futures contract represents no more than a
synthetic option position).
Table 6.2 reflects the four basic spot markets in the
first column. Options (or their synthetic positions such
as futures and swaps) on these four basic spot markets

Table 6.2: Spot and options markets matrix

Options markets
Commodities Currencies Equities Debt instruments
Spot markets
Options/futures on
Commodities
e.g. gold

Options/futures
Currencies on e.g. the rand
exchange rate

Options/futures
Equities
on equities

Options/futures
Debt instruments
on bonds

Financial Regulation in South Africa: Chapter 6 125

are shown in columns 2 to 5. The diagonal of
combinations shown in Table 6.2 represents “pure”
instruments (in contrast to hybrid instruments) in the
sense that the derivatives are linked directly to the
underlying spot market. In the case of the hybrid
instruments, two of the four basic spot markets are
combined.17 For instance, an Equity Linked Fixed
Interest (ELFI) stock was a hybrid instrument, as it
was based on a debt instrument in the spot market with
an equity-linked option attached to it.
2.5 Types of financial markets and
their regulation
Financial markets can be conceptually divided into
various components or forms depending on the criteria
employed. For instance, on the criterion of whether
new or existing securities are being traded, a
distinction can be drawn between the primary- and
secondary-securities markets, whereas the way prices
are determined on a market will result in order- or
quote-driven markets. Moreover, the trading
mechanism used may result in a classification based
on floor, screen or automated-trading markets. Lastly,
markets can also be classified in terms of the capacity
in which traders may trade (i.e. single or dual
capacity). All these issues and their regulatory aspects
are briefly discussed in this section.
2.5.1 Primary and secondary
securities markets
Depending on the criteria of whether new or existing
capital is at stake, the securities market can be divided
into two components: a primary market dealing in the
creation or redemption of securities, and a secondary
market engaged in the trading of existing securities.
The primary securities market
Transactions in the primary-securities market affect
the size of the securities market. The pool of money
invested in the primary-securities market can change
17
This interdependence of financial markets implies that a single
transaction may involve several markets and instruments
simultaneously. The regulatory authorities cannot therefore focus
solely on one market or instrument.
126
only if the amount of scrip18 changes, which can occur
only with transactions such as new issues or listings,
rights issues, the winding-up of existing companies
and the buying back of their own shares by companies.
The secondary securities market
Transactions in the secondary-securities market affect
the money flow through the market. For instance, the
buying and selling of existing securities are secondary-
market transactions. If investors decide to turn their
paper wealth into cash, someone else has to be willing
to turn cash into paper wealth. Transactions in the
secondary market impact on securities prices, and thus
market capitalisation.19 They also impact on market
liquidity, but do not affect the size of the securities-
market pool. Indeed, changes in securities prices are
needed to make sure that there is a buyer for every
seller. In short, transactions in the primary market
affect the pool of money invested in securities,
whereas transactions in the secondary market affect
perceived wealth or market capitalisation.
The regulatory response to primary and
secondary markets
Inherent in the nature of the primary market, the
regulation of newly created securities is mostly
enforced by the legislation governing financial
instruments (see Section 1.2) and the listing
requirements for those instruments on exchanges.20
In the secondary OTC markets, the authorities rely
mainly on market monitoring and disciplines, incentive
structures and corporate governance rules, but that
portion of the secondary market that is “exchange-
18
The term scrip is used here in a broad sense, as securities can be
immobilised or dematerialised through central depository
mechanisms. For instance, bonds in South Africa have been
immobilised since 1994.
19
That is, the value of the total stock of securities outstanding.
20
A distinction should be drawn between primary market activities
in the equity and bond markets. In the government bond markets,
securities can be issued by private placing, on a tap basis or via
auctions. The latter method is used by the National Treasury to
allot tranches of key benchmark bonds to a panel of primary
dealers appointed by the department. These institutions, which
have an obligation to bid for a minimum allotment at each
weekly auction, then sell the bonds so acquired into the
secondary market. These benchmark bonds are, however, already
listed on BESA.
Financial Regulation in South Africa: Chapter 6
regulated” is subjected to additional and extensive self-
regulation in terms of the exchange’s rulebook.
2.5.2 Auction-, quote- and order-driven
securities markets
The trade in commodities and financial instruments can
conceptually be divided into three classes: auction-
driven markets, quote-driven markets and order-driven
markets. The auction-driven markets are usually
classified according to the different institutional rules
governing markets, which determine the bidding
incentives and therefore the terms and the efficiency of a
market. It has become standard now to distinguish
between the following primary types of auction markets:
Auction-driven markets
• English auction. The auctioneer starts at a low
price and would-be buyers bid higher and higher
prices till the auctioneer is unable “to knock down”
an even higher price. The advantage of this auction
type is that the buyer has a second chance to
change his pricing strategy, while the seller can
announce a reserve price (provided the auction
house allows this). Examples of these markets are
found in livestock markets of the United States or
the wool markets in Australia.
• Dutch auction. Under this procedure, the auction
starts at a somewhat higher price than buyers are
willing to pay, and the auctioneer decreases the
price in decrements until a buyer shouts “mine”.
The major advantage of this type of auction is
that any form of trade collusion or conspiracy
(such as bid “ramping”) is impossible, as leaked
information is not feasible. Examples are the cut-
flower markets in the Netherlands and the fish
markets in the UK. True Dutch auction procedures
are rare in financial markets.
• First-price auction. This is the common form of
“sealed” or written-bid auctions, in which the
highest bidder is awarded the item at a price equal
to the amount bid. For about fifty years the US used
this method to trade its weekly primary auction of
short-term US Treasury securities. In South Africa
this method is used for the sale of Treasury bills
Financial Regulation in South Africa: Chapter 6
and Treasury bonds and has in the past been utilised
for one-off gold sales, e.g. by the IMF.
• Second-price auction. Here the highest bidder is
awarded the item at a price equal to the bid of the
second-highest bidder. This method of auctioning
was used for many years by the US Treasury to sell
its long-term bonds. In South Africa this method is
used for the sale of inflation-linked government
bonds, which are sold at the auction price that
clears the market requirement (which may be the
second price or even lower).
• Tâtonnement auction. This auction model “fixes” a
price equilibrium between the quantity offered and
purchased for a specific item, irrespective of
whether the market participants operate as buyers
or sellers (i.e. sellers become buyers if the
proposed price is below the equilibrium price). The
London Bullion Market uses this method of
auctioning to fix its prices.
The attributes that auction markets have in common
are that they aim for the maximum number of buying
and selling orders possible by limiting the number of
trading hours and, unless sellers have reserve prices,
the realised market prices are not known prior to the
auction. Many permutations of the auction-market
model are possible, as for instance each model can be
used either in single-object (e.g. one specific
commodity or security) or multiple-object (e.g. the
auction of slave families in the past) unit auctions. In
auction-driven exchanges such as the London Bullion
Market, trade takes place at the “standard” (or single)
price (i.e. the buying and selling prices are the same).
The standard price is the price at which the greatest
possible turnover takes place in the market and is
based on numerous buy and sell orders. Once the
standard price is fixed, it is generally valid for the day
of trading. The concentration of orders makes the
auction-driven exchanges particularly suitable for
illiquid markets. However, if the market is
characterised by uneven supply and major economic
power concentration, the auction-driven market may
be open to abuse, since established groups may
manipulate the price-forming process. (Unless of
127
course the Dutch auction method is used, but this
method has other inherent shortcomings, such as
greater price volatility if trading volumes are low).
Quote-driven markets
In sharp contrast to the auction-driven markets, trade
in the quote-driven markets can take place throughout
the day. As buyers and sellers know prior to their trade
at what price they are willing to deal, there can be no
unhappy surprises. However, liquidity may be poor in
these markets if strongly capitalised market makers do
not support trade. Two major types of quote-driven
markets dominate:
• Market-maker market. Here customer orders are
transacted with market makers – who are dual-
capacity traders (see Section 2.5.4 below) – who
specialise in the trading of specific securities and
who quote firm prices all times. True market
makers are committed to these quotes to buy or
sell, and the spread between buying and selling can
become expensive if trade is either thin or volatile.
Examples are the London Stock Exchange and
BESA21 in South Africa.
• Quote-driven dealership market. Customers’
buying and selling orders are directly “matched” on
the exchange with the assistance of brokers.
Brokers in turn are supported by “jobbers” – who
are single-capacity traders trading exclusively with
brokers or for their own account and who provide
inter-broker services by quoting two-way price
spreads (but are not committed to their quoted
prices for large volumes). In essence, the jobber
plays the role of an auctioneer in a quote-driven
market. An example of such a market was the
London Stock Exchange prior to the Big Bang in
1986. In the aftermath of “big bangs” on exchanges
around the world, dual-capacity trading has
become the norm and the jobber function
21
In BESA customer orders are not necessarily routed to the
primary dealers (market makers) as a matter of routine, but are
executed in the market if they can be. If not, then the primary
dealers are requested to quote. Primary dealers are not obliged to
display continuous doubles (buy and sell quotes) to the market,
but have to quote on request. In this respect they are not true
market makers.
128
redundant. Exchanges now operate a market-maker
market or an order-driven market.
As in the auction-driven markets, various
permutations are possible in the quote-driven markets.
These, subtle, differences may have a significant
impact on market liquidity. For example, the
dealership model can operate on single or multiple
dealerships, which impacts on trading methods22.
Moreover, in the United States, dealers and market
makers are not obliged to offer all customers’ orders to
the market if they can net them off in their own trading
books. The result of this trading practice is that many
American dealers are operating like a “micro-
exchange” in their own right, although strictly
speaking no exchange functions are executed but
merely a large scale offsetting of various buying and
selling orders in the trader’s own book.
The market-maker market is used by the BESA in
South Africa. These markets are relatively new and
primarily wholesale markets. The advantages and
disadvantages of the market-maker markets are
summarised in Table 6.3.
Order- or order-book-driven markets
Trade in the order-driven markets can also take place
throughout the day. As in the quote-driven markets,
buyers and sellers know prior to their trade at what
price they are willing to deal. Again, liquidity may be
poor in these markets if strongly capitalised market
makers do not support trade. In an order-driven market,
customers’ buying and selling orders are directly
“matched” on the exchange with the assistance of
brokers or by an ATS. Incoming orders are offset
against standing orders previously submitted to the
market or are placed in the order book until such time
an offsetting order is submitted. As no spread has to be
paid (except the brokerage), this method of trading is
cheaper for market users than a market-maker method,
22
Today, nearly a third of all retail orders placed for equities in the
US are routed through the Internet. In essence the Internet is
merely a new medium of communication. Orders placed through
the Internet are generally funnelled into an order/time priority
engine, which is linked via the brokerage firm directly to an
exchange’s trading system. Therefore the Internet interface can be
seen as a “funnel” channelling trades into the regulated markets.
Financial Regulation in South Africa: Chapter 6
but if market liquidity is low it may take time to execute
orders. This is the method now used by Tradepoint in
the UK and also since inception by the JSE23. The trend
appears to be towards order-driven systems.
Where automated-trading systems are used, there is
no need for an intermediary at all, as the computer
system will do the “matching” of orders. However the
JSE, like most exchanges, requires orders to be
submitted through brokers.
South Africa has a tradition of equity trading which
differs from that of the London Stock Exchange in that
it has never had recognised “jobbers”. Even today,
financial securities are traded on the South African
exchanges either in the form of a market-maker market
(usually referred to as a “quote-driven market”) or an
order-driven market. However, the primary markets
for Government bonds and Treasury bills in South
Africa are based on the auction-market methods
discussed above.
The order-driven market is still used by the JSE.24 It
has operated satisfactorily over the years. Table 6.4
summarises the advantages and disadvantages of such
an order-driven market.
23
Today, on the JSE’s ATS (i.e. the JSE Electronic Trading system
or JET) price and quantity are fixed prior to the order being
submitted, whereas in the former “open outcry” system, only the
price was fixed.
24
On the JSE orders are now electronically matched and executed
on the JET system.
Table 6.3: Quote-driven market system
Advantages
• Promotes continuous price quotation
• Promotes liquidity in the market
Financial Regulation in South Africa: Chapter 6
The regulatory response in respect of auction-,
quote- and order-driven markets
Generally the regulatory authorities worldwide leave
it to market participants to decide for themselves
whether they will use either auction-, quote- or
order-driven pricing systems, provided the interests
of the general public are not impaired (i.e. consumer
protection issues). As the BESA, SAFEX and the
OTC markets in South Africa are primarily
wholesale markets, the authorities had no objections
to the use of the market-maker method in these
markets, while the use of the order-driven market
method on the JSE is to a large extent based on the
relatively large retail component in this traditional
market. However, as the retail component of the
stock market is increasingly giving way to unit trust
managers, portfolio managers and the like (i.e. the
retail component on the stock market becomes
increasingly wealthy and knowledgeable
individuals), the need for consumer protection is
decreasing. In essence all financial exchanges are
today wholesale markets, which in turn is likely to
influence regulatory structures in time to come.
2.5.3 Trading systems of securities markets
Irrespective of whether a market is order- or quote-
driven, it can employ various trading modes to effect
transactions. The following major trading systems can be
Disadvantages
• Expensive to operate (market makers may have to
be paid for their services)
• May stall in times of great market volatility when
market makers are reluctant to quote two-way prices
• Market transparency is less than in the order-driven
markets (market makers may demand time delays in
information dissemination to unwind big deals)
• Extensive rulebooks are required to provide
protection to investors
• Less tradable shares tend to become even less so
as market makers are reluctant to make price
commitments (or spreads become excessive)
129
distinguished: floor trading; telephone/screen-quotation
trading; screen trading; and fully automated trading.
Floor-trading system
Dealing on a floor market is done by way of “open
outcry”, i.e. traders meet each other face to face and
“shout” their buying and/or selling prices out loud.
Inherently, floor trading usually implies trading
on a regulated market. The major advantages and
disadvantages of floor trading are summarised in Table
6.5. Of the major exchanges today, only the New York
Stock Exchange and three futures exchanges in Chicago
still do floor trading. However, it seems that even these
exchanges are bound to change over to electronic
trading in the next few years (as competition from other
exchanges – particularly Nasdaq – is proving too great).
Telephone/screen-quotation trading system
In essence, this is a telephone market in which buyers
and sellers negotiate a financial transaction over the
telephone. The screen (usually a Reuters or Bloomberg
information screen) is used only to advertise prices,
but these prices are not, strictly speaking, binding. For
Table 6.4: Order-driven market system
Advantages
• Less expensive for market users (e.g. no price
spread to be paid)
• Less need to commit capital
• More transparent than the market-maker market
• Less costly to supervise than the market-maker
market
• Can be more easily automated
Table 6.5: Floor-trading system
Advantages
• Access to the market for participants at all times
(e.g. no power-failure impact)
• Personal contact of the trader with the market
• All misdemeanours are visible to other traders, who
could report to exchange management
130
instance, a trader can always avoid being “hit” at his
quoted price by saying that he has just traded at that
price and now wishes to give a “new” quote.
Telephone/screen-quotation trading usually takes
place in OTC markets, although it is still used on an
exchange for the larger trades (e.g. at the BESA and
SAFEX)25. However, from a supervisory point of view
this system is unsatisfactory, as its audit-trail
technology is poor.
Screen-trading system
Under this trading system, firm quotes are made on an
electronic trading screen (usually good for a specific
amount) and transactions are finalised by telephone.
Screen trading requires a central clearing-house and
usually (but not necessarily) an exchange that is quote-
25
SAFEX prescribes the use of its ATS for all trades, although
large block trades and structured transactions may be concluded
off-ATS provided they are booked through the ATS within 24
hours. BESA permits the use of its ATS alongside more
traditional quotation/trading mechanisms such as vendor quote
systems, inter-dealer broker (IDB) screens and telephones.
Disadvantages
• Execution of orders may take time
Disadvantages
• Expensive operations in terms of building and skilled
staff
• Surveillance is difficult
• Open to abuse such as trade rigging
• Alienation of remote participants
• Inflexible with regard to future physical market
growth and product growth
• Perception of an exclusive club
Financial Regulation in South Africa: Chapter 6
driven. A screen market usually has the following
characteristics:
• All trade (buying and selling) has to be recorded on
the screen system of the exchange.
• The screen should always show the best price
quoted in the market.
• All transactions have to be reported by participants
on the exchange within a few minutes.
• All telephone conversations of market makers have
to be recorded.
• The front-end clearing system should operate as a
central checking system independent of the
exchange’s automated quote system.
The major advantages and disadvantages of screen
dealing are shown in Table 6.6.
Although the screen system is a major improvement
on the telephone/screen-quotation trading system, it is
nonetheless often seen as an interim step between floor
and fully automated trading systems.
Automated-trading system (ATS)
Under the ATS all the routing of orders and trading is
fully automated using a screen, i.e. buyers and sellers
perform their transactions using only the central
automated-trading system that shows the prices and no
telephone is required. The ATS can be used in the
formal and informal markets, although it is more often
used by exchanges.
Table 6.6: Screen-trading system
Advantages
• High technology, which makes the geographic
spread of participants possible, even on a globalised
24-hours a day basis
• Virtually instantaneous dissemination of information,
which facilitates supervision
• Relatively inexpensive to operate (requiring fewer
staff and less space)
• Availability of information on market depth, e.g.
showing the best price at all times, which makes
trade rigging more difficult
• Higher efficiency (less paperwork) with fewer
transcription errors
• Lower transactions costs
Financial Regulation in South Africa: Chapter 6
The idea behind an automated routing and trading
system is that a central marketplace, in which prices
and volumes of trading for each instrument are
transparent, best serves investors. Large investors (who
may be exchange members) can therefore deal on their
own behalf and are no longer dependent on brokers to
find the “best price”. By contrast, small investors, who
are not exchange members, have to deal with a broker,
as they have no direct access to the ATS.
Compared with floor and screen trading, the ATS
offers some major advantages, as reflected in Table 6.7.
A significant advantage of the ATS is the ability to
build in many pre-trade compliance checks, in this
way reducing the costs of surveillance of the
marketplace. Checks to ensure the appropriate
qualification of traders, fairness of pricing, appropriate
client registration, authority to trade and availability of
funds before the transaction is completed, are
commonplace features of ATSs and lead to a much
reduced need for post-trade analysis26.
26
Inter-dealer broker systems (IDBs) are a feature of global financial
markets, particularly active in bond, currency and derivative markets.
An IDB operates as a “matching engine” either on a name-give-up or
no-name-give-up basis. IDBs utilise a voice box or screen-based
system for putting exchange members or OTC market participants in
contact with one another. Alternatively, an IDB may stand in the
middle of each transaction (as buyer and seller) thereby “protecting”
the names of the two counterparties. In the South African bond
market, four IDBs are active and all are members of BESA.
Disadvantages
• Reliance on electronic communication systems,
which may fail at critical times
• No visible presence of market
• Dealers may decide not to answer incoming
telephone calls
• Deferred reporting of large trades to forestall “piggy-
backing”
131
 A drawback of the ATS is that it is less appealing in
a quote-driven market where large participants prefer
to negotiate directly with the market maker rather than
deal at the price quoted on the screen. To date, only
one fundamental problem has been identified with
ATSs using the quote-driven system (e.g. on the LSE
in the UK), namely that of handling pre-arranged deals
(i.e. deals negotiated on the telephone and then
executed on the ATS within seconds).27
The BESA, JSE and SAFEX all have automated-
trading systems, and all allow major deals to bypass
the system as traders are fearful of submitting firm
prices to the system for large volumes. Moreover,
nearly all option contracts, except those on SAFEX,
are traded on a telephone/screen basis in South Africa,
as option strategies are typically too complex and non-
standardised for automated systems.
The regulatory response to trading systems
With the development of the ATS, there is a tendency
worldwide for the authorities to prefer ATS trading, as
it has superior audit-trail technology (which ensures
investor protection) and pre-trade compliance
procedures, and also facilitates dual-capacity trading.
27
This can be overcome by allowing “report only” trades through
the ATS. This is not a problem with the order-driven mechanism
(as used, for instance, by the JSE).
Table 6.7: Automated-trading system
Advantages
• Major cost saving in comparison with floor trading –
thus ATS leads to competitive advantages
• Strict pre-trade compliance procedures have to be
fulfilled which ensure compliance even before the
trade is done
• Superior audit-trail technology compared with floor
and screen trading
• Anonymity of trading parties is possible (but still
secures price transparency)
• Guarantees methodical order matching by mechanical
application of price and time priorities
• Guarantees efficient price formation by immediate
and automatic display of executed orders, not only
on trading screen, but also on public vendor screens
132
Most regulatory authorities seem willing to accept the
problem of pre-arranged deals on an ATS because:
(i) wholesale clients (doing “block” trades) may well
demand a different price from retail clients; (ii) cost-
benefit analysis has indicated that the closure of this
“loophole” would be too expensive; and (iii) these
practices exist with other trading systems as well.
The South African regulatory authorities leave the
choice of the specific trading system to market
participants. By encouraging competition among
exchanges, market discipline will ultimately enforce the
most effective and cost-efficient system. However, there
are two major problems where two, especially domestic,
exchanges are in direct competition (i.e. the same
securities are listed on both exchanges): (i) the reduction
or splitting of market liquidity; and (ii) the difficulty and
cost of monitoring activity across two exchanges.28
2.5.4 Single- and dual-capacity trading
on exchanges
Single-capacity trading, in the pure sense of the word,
means that exchange members may trade as brokers or
jobbers only, whereas dual-capacity trading allows
28
The South African playing field is not very level – e.g. SA
companies can only list overseas with Ministerial approval, whereas
overseas companies are free of any form of exchange control.
Disadvantages
• Reliance on electronic communication systems,
which may fail at critical times
• Excludes the possibility of negotiating a price directly
with the market maker
• Pre-arranged trades are difficult to prevent
• Loss of personal contact
Financial Regulation in South Africa: Chapter 6
exchange members to trade for clients and for their
own accounts. The aim of a single-capacity trading
rule is to avoid any conflicts of interest (e.g. front-
running). However, a liquid market often depends on
active market makers, which in turn may necessitate
dual-capacity trading.
Traditionally, stock exchanges required members to
trade in single capacity and as a natural persona (i.e.
with unlimited liability). This implied that members of
the exchange had to be either brokers or jobbers. Dual-
capacity trading, as existed in the OTC markets, used
to be prohibited on exchanges, as this was thought to
be bound to lead to front-running.29 However, with the
development of ATS trading, there is no longer a need
for single-capacity trading rules, as the audit trail of
these electronic systems is superior to that of any other
29
That is, buying for own account first and only thereafter for
client account during a bull market – and mutatis mutandis
during a bear phase – ensuring virtually risk-free profits for the
broker at the expense of the client.
Table 6.8: Single-capacity trading rule
Advantages
• Avoids conflict of interest for exchange members
• Inexpensive form of consumer protection from a
regulatory point of view
• Particularly suitable for illiquid markets
Table 6.9: Dual-capacity trading rule
Advantages
• Allows for both single- and dual-capacity trading at
the choice of exchange members
• More competitive than single-capacity exchanges
Financial Regulation in South Africa: Chapter 6
trading system. Accordingly market making – and thus
dual-capacity trading – became a possibility on
exchanges as well.
The advantages and disadvantages of single- and dual-
capacity trading are summarised in Tables 6.8 and 6.9.
The regulatory response to single- and dual-
capacity trading
In principle the regulatory authorities generally prefer
dual-capacity trading to single-capacity trading
because dual-capacity trading improves competition
and efficiency. Since the late 1980s, the necessity for
single-capacity trading has virtually disappeared in
practice, as ATS trading can cope with most trading
problems that in the past would have necessitated a
single-capacity rule.
2.6 The regulatory regime and structure
of financial markets
The regulation of markets should be conceptually
differentiated from the regulation of market
Disadvantages
• May harm market liquidity, as this rule makes market
making impossible
• Should brokers be undercapitalised, this rule also
requires unlimited liability for exchange members
(and thus the exclusion of corporate exchange
membership)
• An exchange operating under this rule will find great
difficulty in facing competition from (foreign) dual-
capacity exchanges and informal markets
Disadvantages
• Under this rule traders have to be well capitalised,
which in turn may result in powerful securities firms
ousting small broking firms
• Requires sophisticated audit trail technology to
protect investors
• Requires a sufficient degree of market liquidity from
the outset
133
participants, which are by nature individuals or
institutions. For example, a formal exchange is
subjected to stringent entry (licensing) requirements,
which differ significantly from those applicable to
exchange members. Likewise, although exchange
members are subjected to corporate governance rules,
the markets themselves are usually not. The regulatory
regime impacts on the markets primarily in areas such
as entry and standards requirements (e.g. licensing
conditions); ownership constraints (e.g. until the Big
Bang on the JSE in 1995, membership of the exchange
was limited to juristic persona with a minimum of 10
such persons); functional constraints (e.g. the JSE may
not trade in futures); jurisdictional constraints (e.g. the
JSE’s jurisdiction is limited to South Africa); pricing
constraints (e.g. until 1995 trading on the JSE was
allowed only at prescribed brokerage fees); and
operational constraints (e.g. trade may only be done
with exchange members).
Besides these formal rules and regulations, markets
are also subject to market discipline and monitoring. It
is primarily the competition among exchanges that
ensures that trading, clearing and settlement systems
use the latest technology. It is also competition that
results in the demise of unsuccessful (expensive)
exchanges. In short, markets have to prove to other
(often foreign) competing markets that they are well
capitalised, safe and sound. Market discipline in the
OTC markets is not necessarily less stringent than in
the exchanges but because formal markets are also
involved in retail trade, their consumer protection rules
are more extensive than those found in the (typically
wholesale) OTC markets. The conceptual regulatory
matrix is shown in Table 6.10, and is discussed in
somewhat more detail below.
2.6.1 The OTC market
In terms of turnover, the foreign exchange and money
markets are both large. For example in 1999 turnover
on the JSE amounted to R448 billion, compared with
R2 375 billion in the South African forex market.
Usually the entry requirements in the OTC markets
depend on the balance sheet strength of the participant,
134
since trading, clearing and settlement procedures are
done directly between market participants. In the
foreign-exchange market use is made mostly of the
Reuters or Bloomberg information systems, while
clearing and settlement is done through local or
overseas clearing banks (using the SWIFT
confirmation and instruction system).
Cross-market exposures are controlled in the forex
market by integrating all spot, forward and option
positions of members in one overall risk exposure.
Ultimately the net forex exposure of South Africa is
limited by the available credit lines of foreign
participants. In respect of the money market, no cross-
market risk management takes place as all contracts
are entered into between two specific counterparties,
who will see each other as ultimate credit risk takers.
Two pieces of legislation are particularly important
for the OTC markets, namely the Companies Act and
the Currency and Exchange Act (1933). It is the
Harmful Business Practices and the Consumer Affairs
(Unfair Business Practices) Acts that ultimately
determine issues such as fair trading, while the
Currency and Exchange Act gives rise to South
Africa’s regime of exchange control. However, most
of the powers of the Exchange Control Department of
the SA Reserve Bank are focused on the market
participants rather than the forex market as such (see
Section 3.2.1 below). For example, Exchange Control
stipulates that local residents, except authorised forex
dealers, are not allowed to trade foreign exchange.
Likewise, the rand/dollar futures contract traded on
SAFEX is limited to foreigners and the authorised
forex dealers in South Africa.
2.6.2 The formal market
Exchanges are subjected to far more formal rules and
regulation than the OTC markets. The most important
constraints are the Companies Act, the Insider Trading
Act, the Stock Exchanges Control Act (SECA), the
Financial Markets Control Act (FMCA), the Currency
and Exchange Act, the Directives of the Registrar of
(non-bank) Financial Institutions, and the self-imposed
rules of the exchanges in areas such as advertising and
Financial Regulation in South Africa: Chapter 6
 Table 6.10: Regulatory matrix: Financial markets
Institutional safety and
Regulatory ultimate objectives Systemic stability Consumer protection
soundness

Regulatory
intermediate goals

liquidity
fairness
schemes

neutrality
disclosure

Proper risk
retail funds

assessment
Competitive
Integrity and
Competence
Protection of

infrastructure
infrastructure
Fit and proper
Access to retail

competitiveness
competitiveness

Sufficient market

Financial Regulation in South Africa: Chapter 6

financial services

market exposures
Acceptable cross-
Transparency and

directors and staff

Global institutional

Proper institutional

Competitive market
Retail compensation

currency mismatches
Securities markets as
Regulatory regime and

efficiency and economy

Acceptable maturity and

Regulatory effectiveness,
Adequate product/service

its instruments

alternative to intermediation
1. Official rules and regulations
1.1 Entry and standards constraints X X X X X X X X X X

1.2 Ownership constraints X

1.3 Functional activity constraints X X

1.4 Jurisdictional constraints X X

1.5 Pricing constraints X

1.6 Operational constraints X X X X X X X X X

2 Official monitoring and supervision X X X X X X X X X X

3. Intervention and sanctions X X X X X X

4. Incentive contracts and structures X X X X X X

5. Market monitoring and discipline X X X X X X X X X X X X X

6. Corporate governance

7. Discipline/accountability of
regulators

135
sponsorship. Since the Big Bang on the JSE in 1995,
the traditional constraints on ownership and pricing
have fallen away on the JSE, and the aim of the
authorities is now to consolidate the SECA with the
FMCA into a new act (probably named the Investment
Services Act).
The entry and standards constraints for an exchange
largely centre on the licensing requirements, risk-
management systems and guarantee or fidelity funds.
The functional constraints are that the securities traded
on an exchange may only be listed securities (e.g. not
the shares of a private company – “(Pty) Ltd”).
Moreover, the rules and regulations of the exchange
stipulate in detail which securities may be traded on the
exchange. The jurisdictional constraints limit
exchanges’ operations to South Africa (so far as they
apply to listed securities30), although efforts are being
made to extend this to the Southern African
Development Community (SADC) region. The
operational constraints are not only the familiar
prudential requirements and code-of-conduct
requirements (such as appropriate capital adequacy and
the avoidance of conflicts of interest), but also contain
conditions that trading must be limited to exchange
members only. Official monitoring and supervision are
undertaken by both the Financial Services Board and
the inspectorates of the exchanges and is aimed at
enhancing the institutional infrastructure, and at
avoiding insider trading and fraud.
Despite all these formal regulations, market
discipline remains crucial to ensure effective and cost-
efficient trading on exchanges. Local exchanges have
to compete successfully with foreign exchanges such as
the London Stock Exchange to remain in business.
Remote trading31 by foreign members of the exchange
30
The exchanges in South Africa are free to make their systems and
services available to the OTC markets or to markets offshore,
which activities would fall outside the ambit of their financial
market licences and constitute a separate line of business. A
problem experienced with exchange rationalisation in South
Africa was due to the mix of retail and wholesale business –
SAFEX and BESA are wholesale and employ clearing or
settlement members whereas the JSE does not.
31
Remote trading means that foreign participants can also use the
exchange facilities by means of electronic networks.
136
increases local liquidity, but also increases foreign
competition.32 Moreover, there is keen competition
between the underlying market (e.g. the equities quoted
on the JSE) and the derivative market (i.e. options and
futures on those equities or indices based on them on
SAFEX). It is primarily the forces of competition that
lead to innovation and technological enhancements.
2.6.3 The structure of the market regulators
The regulatory structure is unique for every market
and every country, as no two countries have identical
legislative structures. Different circumstances often
demand different structures in order to ensure effective
and cost-efficient regulation. In principle there are
three basic models:
• A single regulatory authority for each basic market,
in which case one regulatory authority regulates all
relevant activity in one basic market (e.g. in the
currencies markets).
• More than one specialised regulatory authority for
activities within basic markets, implying that parts
of one basic market are regulated by various
specialist regulatory authorities. This structure is
found in South Africa where spot and derivative
instruments in the same basic market (e.g. equities
market) are supervised by different self-regulatory
organisations.
• A separate entity for the three basic functions33 of an
exchange: (i) execution; (ii) clearing and risk
management; and (iii) settlement and delivery. In
terms of such a model the exchanges will
concentrate exclusively on their execution functions,
while the clearing of all their trades will be done by a
32
Remote trading currently occurs at SAFEX, and at some future
date this may also happen at the BESA or the JSE. In the South
African bond market, foreigners participate in one of two ways:
either via direct trading with member firms (known as non-
resident trading) or directly among themselves (e.g. two foreign-
based entities) in the OTC market. This turnover represents some
35% of the exchange’s overall annual turnover. Remote
membership of a local exchange will have a significant impact,
particularly in the bond market, as the “foreign” primary dealers
have invested significantly in setting-up local operations to
comply with National Treasury requirements.
33
Also referred to in the market as “platforms”.
Financial Regulation in South Africa: Chapter 6
 separate specialist institution or even a few
competing clearing-houses (e.g. like Euroclear and
Clearstream in the currency markets). The settlement
of trade can be done by either that same clearing
company or by a separate settlement company.34
The single regulatory authority for each
basic market
In terms of Table 6.2 (Section 2.4), a single regulatory
authority for each basic market implies that the matrix
should be read in rows. In this case, supervision centres
on only four basic markets (namely commodities,
currencies, equities and debt instruments), each
embracing both spot and derivative instruments.
Control over hybrid financial instruments is relegated,
virtually by definition, to the underlying spot market.
The advantages emanating from the regulation of
one basic market by one single regulatory authority for
each basic market35 can be summarised as follows:
• Reduced risk profile between markets. Since one
regulatory authority supervises both the spot and
derivative markets in a specific instrument, the
potential for a squeeze in the underlying market36
is substantially reduced.
• Recognising explicitly the markets’
interdependence. The spot, futures and options
markets, though often physically separated, have
actually become so closely intertwined as to
effectively constitute one market. Spot market
instruments can easily be replicated in derivative
markets by way of synthetic spot positions. In fact,
derivative markets can attribute their existence
almost solely to differing views (expectations) held
about the spot market price.37
• Assigning regulatory responsibilities more clearly.
If a single regulatory authority accepts responsibility
for the safety and soundness of one basic market,
34
Other functions of an exchange, e.g. listing requirements and, for
equity exchanges, corporate actions (e.g. financial statements to
shareholders) would remain within the core exchange.
35
That is, a single self-regulatory organisation or SRO.
36
Arising from demanding the physical delivery of large short
positions created in the derivatives market.
37
In “pure” theory, derivative markets are not considered, as such
theoretical constructions assume perfect market information.
Financial Regulation in South Africa: Chapter 6
quick action can be taken to address possible
difficulties. Splitting the responsibility, and hence
the regulatory authority, for one basic market can
undermine orderly and regulated market structures.
• Avoiding harmful competition between exchanges.
The commercial success of any market is highly
dependent on market liquidity, although derivative
markets are even more dependent on liquidity than
spot markets38. If two exchanges offer similar, or
virtually similar, products in competition with each
other, market liquidity in both markets would be
impaired and costs increased.
• Legalising the process of netting and novation. To
reduce their capital-adequacy requirements, firms
want to offset (or net) their long/short trading
positions in the underlying market against short/
long positions in the derivatives market. Although
the regulatory authorities are willing to allow such
offsets in formal and in OTC markets, the legislator
(in the case of bankruptcy) only allows netting and
novation under specific conditions39.
• Greater agreement with historical precedence. One
of the oldest derivative markets is the forward
currency market. This basic market operates as a
single entity, embracing both spot and forward
transactions.
Specialist regulatory authorities for activities
within basic markets
One basic market can be supervised by various
regulatory authorities, each specialising in a specific
activity of that market. For instance, in most
countries – including South Africa – the futures market
is regulated as a separate market, independent from the
38
Accordingly, derivative markets are quick to remove illiquid
products from their exchange.
39
Novation is the introduction of two new trades both with same
central counterparty (which trades replace the original one
between the two ultimate counterparties). By definition, novation
can only take place on one exchange. By contrast, netting the
exposures in underlying and derivative instruments across
counterparties can be achieved even though the instruments are
traded on different markets (a complex process though). In South
Africa, the Insolvency Act specifically recognises (in section
35A) that the netting processes of an exchange have legal
standing and furthermore the Act binds liquidators to observe
these practices.
137
underlying spot market. This regulatory arrangement is
often favoured for the following reasons:
• Increased business efficiency. Although systemic
risk management may favour a single-regulatory
authority, trading all futures on one exchange may
nonetheless enhance business efficiency
(economies of scale and scope).
• Evading the single-capacity trading constraint.
Traditionally exchanges operating the spot markets
were based on single-capacity trading. As corporate
participants were often not allowed to participate in
these exchanges, they created a separate market
where they could trade the synthetic equivalent of
the underlying spot market, without encountering
the trading constraints of spot markets.
Specialist platforms for exchange execution,
clearing and settlement functions
This regulatory arrangement entails that the basic
functions of an exchange are unbundled first and then
aggregated again across markets per platform. For
instance, the three existing exchanges, BESA, JSE and
SAFEX, could compete in terms of their execution
skills (basically trade in information assimilation), but
share the same clearing and risk-management platform
and/or even the same settlement and delivery platform.
In essence this approach tries to maximise the benefits
of both the single regulatory authority model by
aggregating the clearing and settlement functions across
markets, and the specialist regulatory authority model
by promoting competition between the various spot and
Table 6.11: Listed financial instruments and their markets
Exchange
BESA
Listed instrument
Equities
Warrants on individual equities
Bonds x
Futures
Options on futures
138
derivative markets. As discussed in Chapter 7 (Section
2.4.2) in greater detail, this model would also be able to
harmonise the OTC markets with the formal markets.
2.6.4 The structure of the South African
regulatory authorities
The regulatory structure in South Africa has developed
in an evolutionary way. It followed rather than initiated
the developments in the financial system. Particularly
during the 1980s, major changes took place. For
instance the Office of the Registrar for Banks and
Building Societies was transferred from, at that time,
the Department of Finance to the Reserve Bank in 1987
and the Office of the Registrar of Financial Markets
was established as a statutory body, namely the
Financial Services Board, in 1989. The regulatory
structure is currently still in a transitional stage and
some major changes may still occur. For example it is
still undecided whether South Africa should follow the
British example, by creating one super-regulatory
agency such as the Financial Services Authority.
As a matter of principle, the Registrar of Financial
Markets has elected not to force market structures on
exchanges, which are self-financed. Instead, he has
elected, by and large, to accept the historical
(evolutionary) development of the regulation of the
financial system, which in South Africa was of a
specialist nature (see Table 6.11). In essence, change in
the structure of exchanges has to be brought about by
increased competition rather than regulatory directives.
JSE SAFEX
x
x
x
x
Financial Regulation in South Africa: Chapter 6
 Today, the JSE, as a self-regulatory organisation,
accepts the responsibility for regulating all trade in
listed equities and warrants on individual equities.
SAFEX regulates all futures contracts (i.e. on
commodities, currencies, equities and debt
instruments) and options on these futures, and the
BESA regulates trade in listed bonds. All options on
bonds are traded in the OTC market.
The current regulatory structure may be attractive
from a business efficiency point of view. For instance,
trading all futures on one exchange would generate
important economies of scale. However, the prevailing
regulatory structure also creates some major problems.
Firstly, to ensure proper risk-management procedures,
the rulebooks of the three exchanges have to be
synchronised to avoid situations where trade in one
specific instrument is effectively terminated on one
exchange, but continues on another. In an emergency,
the current structure is complicated and may even
involve the authorities unnecessarily. In effect, the
price paid for greater business efficiency in the private
sector is the increased complexity of systemic risk-
management procedures for the regulatory authorities.
For instance, the rulebooks for all these exchanges
have to be carefully synchronised, not only in terms of
emergency management (e.g. possible circuit breakers)
but also for addressing any dispute between those
exchanges trading in similar products (e.g. procedures
on how to confront a squeeze or corner).
Secondly, the historical approach to the structure of
the regulatory authorities has had the result that the JSE
reports to the Registrar of Stock Exchanges and is
subject to the Stock Exchanges Control Act, whereas
SAFEX and the BESA report to the Registrar of
Financial Markets and are regulated in terms of the
Financial Markets Control Act (see Diagram 6.5)40. It is
expected that this issue will be addressed in 2001, when
the Stock Exchanges Control Act, the Financial
Markets Control Act, the Insider trading Act and the
Custody and Administration of Securities Act are
consolidated into the proposed Investment Services Act.
40
The same person currently performs the functions of Registrar of
Stock Exchanges and Registrar of Financial Markets. To
minimise regulatory arbitrage between the exchanges,
particularly with respect to the application and monitoring of
capital-adequacy requirements, the three exchanges in South
Africa have concluded agreements in terms of which exchange
members must elect a lead regulator for the reporting and
monitoring of capital-adequacy. Where such a member is also a
member of the other exchanges, those exchanges rely on reports
received from the lead regulator as to the quality and quantity of
the member’s capital.

Diagram 6.5: Regulatory structure of exchanges*

Financial Markets Control Act Stock Exchanges Control Act

Minister of Finance

Registrar of Financial Markets Registrar of Stock Exchanges

Rulebook: Rulebook: Rulebook:

Bond Exchange of South Africa SA Futures Exchange Johannesburg Stock Exchange

* The diagram depicts relationships in terms of the Acts and not organisations

Financial Regulation in South Africa: Chapter 6 139

3. Regulation of financial
market participants
Particularly because financial markets are so difficult
to demarcate and therefore to regulate, the authorities
place great emphasis on the regulation of financial
participants41. In effect the deregulation of markets
often goes hand in hand with the reregulation of
financial firms.
Two issues are addressed in this section: (i) financial
market participants in both the OTC and regulated
markets; and (ii) the regulatory regime and structure
for market participants.
3.1 Financial market participants
3.1.1 Participants in OTC markets
In an OTC market, buyers and sellers trade of their
own volition. If these buyers and sellers trade in
securities, they could be ultimate lenders, ultimate
borrowers or financial intermediaries (see Diagram 6.6).
In turn, financial intermediaries can operate as banks,
institutional investors or investment firms, though
those in this last category can again operate as brokers,
principal traders or market makers42 or act in a
combination of these capacities.
Traditionally exchanges were associations of
exchange members (i.e. mutual associations). In terms
of the proposed Investment Services Act an exchange
may now be a corporate body with share capital. In
future an exchange may therefore be self-listed.
Moreover, provision is also being made in the proposed
Act that exchanges do not need to have any members at
all. This necessitates the emergence of the “authorised
41
Participants in the financial markets are primarily financial
institutions. However, large corporates (such as Eskom, Transnet
and Telkom) are also important participants in the regulated
markets. They even make a market in their own bonds.
42
In the South African markets, the South African Reserve Bank
has withdrawn from active involvement in the bond market.
Instead, the National Treasury has appointed a panel of primary
dealers (the major banks which comply with certain minimum
capital and other criteria) which are obliged to bid for a minimum
amount of the department’s weekly auction of government
bonds. Furthermore, these institutions are required to make
markets in these benchmark securities and serve as buyers of last
resort in the event of market disruption.
140
user”. All these changes are required to increase
professionalism and keep pace with global development.
Financial advisers are also a type of financial market
participant, but they are not financial intermediaries.
Usually broking and advice goes hand in hand though,
as good advice results in attractive broking
opportunities. Each of these major participants will now
be briefly discussed.
Banks and institutional investors
Banks and institutional investors (i.e. insurers and fund
managers) play various roles in the financial system,
the most important being their willingness to match
the differing needs of lenders and borrowers and to
assume such credit, liquidity and market (or price)
risks that ultimate borrowers and ultimate lenders are
unwilling to assume and wish to dispose of. Therefore
banks and institutional investors position themselves
between ultimate lenders and ultimate borrowers. They
accept primary securities from ultimate borrowers
(such as trade bills or government stock) and issue
indirect securities (such as NCDs or annuities) to
ultimate lenders (see Diagram 6.6). Since financial
intermediaries are exposed to various financial risks,
they require a sufficiently large capital base.
Investment firms and traders
Traders and market makers buy and sell traded
securities for their own account with the aim of
making a profit. While assuming an investment risk in
the process, traders do not create indirect securities.
They only “warehouse” securities (both primary and
indirect securities)43 for comparatively short periods of
time. In doing so they generate liquidity in the market,
but their ability to add liquidity to the market is
restricted by the extent of their capital resources.
A securities firm is a type of investment firm
(usually a medium- or higher-risk firm) that trades on
an exchange and can be seen as a large-scale market
maker. However, the securities firm does more than
merely “warehouse” securities. It can also operate as
an informal market maker in the OTC markets for
certain securities and so powerfully support financial
43
Warehousing also includes placing the scrip in a central depository.
Financial Regulation in South Africa: Chapter 6
markets in their role of bringing ultimate lenders and
ultimate borrowers together. Indeed, lenders and
borrowers who cannot always meet each other in terms
of credit exposure, liquidity and market risks can still
compromise by utilising the securities market rather
than financial intermediaries. For instance, lenders
may “securitise” their debt instruments by
standardising them in small nominations and issuing
them for relatively short periods, simultaneously
allowing for predetermined rollover dates and having
these issues underwritten by a financial institution
(often a bank and/or a securities firm). These
securitised instruments (the most popular being
commercial paper and note-issuance facilities) are
often supported by securities firms, which – with the
help of computerised trading systems – create highly
liquid markets in these instruments.
Increasingly, credit-rating agencies are undercutting
banks’ comparative advantage in the screening of
borrowers so that today there is a large and sophisticated
pool of investors who are capable of diversifying risks
directly in the capital markets. In effect, the financial
markets themselves address, to a large extent, the
specific requirements of lenders and borrowers, which
have traditionally been accommodated by financial
intermediaries. Accordingly keen competition is
emerging between the traditional intermediation role of
banks – which at times displayed significant
monopolistic trends in their lending and deposit-taking
business – and the securitisation of new financial
instruments by securities firms. Owing to significant
investment risk and the de facto need to support market
liquidity in certain securitised instruments, securities
firms (like banks) need a relatively large capital base.

Diagram 6.6: Financial intermediation versus direct financing

money money

Banks
indirect primary
securities Institutional investors securities

money money

Investment firms
primary primary
securities Traders securities

Ultimate lenders Ultimate borrowers

money

Brokers
(direct financing)

primary securities

Financial Regulation in South Africa: Chapter 6 141

 The development of capital markets has an
important advantage in reducing systemic risk, as
financial systems are likely to be more stable if based
on the two pillars of (i) intermediated credit and
relationship banking, and (ii) strong securities markets.
This is the essential reasoning behind current efforts to
develop bond markets in many developing countries.
To strengthen the financial system the authorities must
cover each of the system’s main pillars, namely
institutions (particularly banks), markets (particularly
the bond market) and the market infrastructure
(particularly corporate governance).
Brokers
Brokers do not assume any trading risks – nor do they
issue indirect securities. They operate solely as agents
on behalf of their clients (see Diagram 6.6).44 They sell
or buy financial instruments on behalf of their clients,
thereby earning a fee (commission). Brokers perform
an intermediary function, as they merely bring buyers
and sellers together. They also offer services additional
to that of the trading function, such as: trading
experience; speed of execution; finding buyers and
sellers; client privacy/anonymity; research; and
standing good for a client in case of default.
Though the requirements of lenders and borrowers
are rather standard, the pure broking function is
increasingly being taken over by automated-trading
systems. However, the broker still plays an important
role in respect of non-standardised financial products.
As agents do not assume any financial risk themselves,
they require limited capital resources of their own.
In an OTC market, participants can operate as both
traders and brokers. For example, large corporates are
not only involved in funding, but may also speculate
on a large scale (jobbing) or conduct broking business.
As the OTC markets are less strictly regulated,
participants are free to choose their type of business,
and consequently large players are often involved in
44
JSE stockbrokers are not “pure” brokers as they can trade with
clients or among themselves for own account. Most trades with
clients are, however, on an agency basis because inter alia
commission cannot be charged on trades with clients on a
principal basis.
142
more than one trading capacity. The only criterion for
participation in an OTC market is acceptance by other
players, which effectively implies an acceptable credit
rating. The OTC markets are therefore often wholesale
markets, subject at times to sudden shakeouts
particularly if credit risk increases.
Financial advisers
After extensive discussions with interested parties for
nearly a decade, the regulation of financial advisers
will probably commence with the proclamation of the
Financial Advisory and Intermediary Services Act in
2001. For a long time a pressing need has been felt by
the authorities to bring financial advisers into the
regulatory net, because advisers and intermediaries
services suppliers are acting as “an indispensable link
in the chain when fraud is being perpetrated on the
public”.45 In terms of the proposed Act, financial
advisers and the intermediaries of financial services
suppliers will be subjected to various market-conduct
rules, the most important being:
• Minimum fit and proper standards for professional
advisers.
• Minimum quality standards for the suppliers of
financial products and their representatives.
• Subjection of the industry to a code of business
conduct.
• Reporting and disclosure rules.
• Complaints and compensation procedures.
• Compliance officer requirements.
• Dispute resolution by an ombudsman.
With the power of this new Act, the authorities hope
to be able to better protect the interests of the
consumer against the inherent problems of asymmetric
information flows46.
However, the regulation of financial advisers will not
only rely on market-conduct rules. The new Act also
contains some strong elements of regulation by
reputation. Rather than trying to depend on too-detailed
45
The Nel Commission of Inquiry, Nov. 1997, p.104.
46
Asymmetrical information problems are one of the major reasons
that small investors do not always fully understand the financial
products they are buying.
Financial Regulation in South Africa: Chapter 6
regulation,47 reliance on a firm’s own self-interests
often works more effectively and efficiently. Regulation
by reputation usually entails the following elements:
• Reliance on firms’ self-interest.
• Firms take responsibility for staff training and
minimum competence standards.
• Firms take responsibility for the blacklisting of
rogue advisers on their products.
• The authorities take responsibility for the
enhancing of competition (particularly foreign
competition).
• Extensive education and information flows to the
media.
• Publication in the media of fines and misconduct.
In essence, regulation by reputation is based on the
assumption that the sale of most financial products is not
fundamentally different from the sale of other (complex)
retail goods such as motor vehicles or computers. Only
those few financial products that are indeed uniquely
complex need additional statutory regulation (e.g.
authorisation and registration requirements).
3.1.2 Participants in the regulated market
An exchange is in essence a regulated marketplace,
operating under its own rules. These rules usually
stipulate trading, clearing and settlement procedures,
as well as risk-management procedures. Membership
of such an exchange often entails entry restrictions48
and is subject to certain requirements such as
minimum capital reserves, certification of certain skills
and levels of experience, business integrity and an
acceptable degree of legal accountability. Exchange
members are usually categorised into three major
types: brokers; principal traders; and market makers.49
47
Which always carries with it the danger of over-regulation and
cost-inefficient regulation – i.e. state failure.
48
Internationally, membership of an exchange is often limited to
investment firms. In South Africa exchange membership is based
on mixed criteria. For the JSE, membership is limited to
securities firms, but the BESA and SAFEX also allow the
membership of banks, insurers and even non-financial
institutions. Securities firms which are members of the JSE may
be subsidiaries of other financial institutions, e.g. banks.
49
In South Africa these roles are often mixed.
Financial Regulation in South Africa: Chapter 6
Each has a specific role to play on an exchange.
• Brokers (or agents). Brokers operate solely as
agents for buyers and/or sellers. They facilitate
direct financing between ultimate lenders and
ultimate borrowers and/or financial intermediaries.
They do not speculate on price movements in the
market and concentrate solely on their role as
agent for which they receive a commission.
Brokers often assume full responsibility for the
retail business.
• Principal traders (or dealers). Principal traders
operate on the exchange for their own account
only. They take a view on possible price
movements and buy or sell for their own portfolio.
They perform the role of wholesalers on the
exchange, often buying and selling large quantities
of securities from and to brokers.
• Market makers (or specialists). Market makers are
specialists in certain securities traded on an
exchange. They create liquid markets in certain
securities by continuously quoting buying and
selling prices – thereby ensuring the existence of a
two-way market. As market liquidity is
asymmetrical (it is high in a bull market, but may
be very thin in a bear market), market makers are
in need of sufficiently large capital resources.
They often have to buy large quantities of
securities during a bear market phase, which they
off-load (or are supposed to off-load) at a later
stage. Market making may therefore be very costly
(or even unprofitable) during a bear run.
Exchanges normally grant certain privileges to
market makers, such as deferred reporting and
executing large orders away from the exchange’s
trading facilities (called “block” trading). These
privileges are granted to attract market makers
with sufficiently large capital resources in order to
increase market liquidity.
Although not every OTC market participant may
trade on an exchange, exchange members are usually
allowed to trade in an OTC market in securities not
regulated by the exchange.
143
 Diagram 6.7: Financial market participants

Financial markets

Investment exchanges OTC market

(formal with eg automated- (informal with eg telephone/
trading systems) screen-quotation trading systems)

BESA
JSE
SAFEX

Banks
Ultimate borrowers
Insurers
Investment firms* and
Fund managers
ultimate lenders
Investment firms

Brokers Principal traders Market makers

* Investment firms that are members of the JSE may be subsidiaries of other financial institutions, e.g. banks.

3.2 The regulatory regime and structure
for financial market participants
Usually financial institutions are functionally divided
into three broad classes: banks, insurers and
investment firms. The essence of banks is that the cost
of their liabilities is fairly certain, but that the return on
their (illiquid) assets is uncertain (mainly owing to the
credit risk on their unmarketable loans); insurers have
mutatis mutandis uncertain liabilities (i.e. as reflected
in the actuarial risk) and certain (mainly marketable)
assets; whereas investment firms have certain
(marketable) assets and also liabilities (i.e. they are
exposed predominantly to market risks).
These three classes of financial institutions can be
subdivided again. Banks can be classified as
commercial banks, merchant banks and mutual banks;
insurers can provide long-term (life assurance) or
short–term insurance; and investment firms can be split
into fund managers, securities traders and brokers.
This section highlights some of the regulatory
differences between these various types of institutions,
with the emphasis on private-sector financial
institutions. The contrast between public-sector
financial institutions and their private sector equivalents
is stark but relatively simple. For all practical purposes,
financial institutions in the public sector are exempted
in full from the usual statutory requirements (as
imposed on private-sector institutions), as their risk

144 Financial Regulation in South Africa: Chapter 6

exposures are backed by the National Treasury.
However, this type of generosity on the part of the
National Treasury is not without inherent problems.
Firstly, it distorts the level playing field concept and
thus competitive neutrality as a regulatory goal, because
public-sector financial institutions do not incur any of
the implicit costs of prudential requirements. Secondly,
this organisational structure implies that the taxpayer,
rather than shareholders or clients, pay for potential
mismanagement. Thirdly, it creates major conflicts of
interest in that these institutions operate under an
implied free-of-charge lifeboat facility. Fourthly, the
lack of profit yardsticks makes it very difficult to
measure the true effectiveness, cost-efficiency and
economy of such institutions.
Be that as it may, the following public-sector bodies
operate under their own Acts of Parliament: (i) the
Postbank is exempted from all the provisions of the
Banks Act (in terms of the Post Office Act); (ii) the
Corporation for Public Deposits is a subsidiary of the
SA Reserve Bank and does not fall under any banking
legislation; (iii) the Land and Agricultural Bank of
South Africa is exempt from the provisions of any
other law, especially those governing banks (in terms
of the Land Bank Act); and (iv) the Public Investment
Commissioners (PIC) are not subjected to the Pension
Fund Act (in terms of PIC Act). In all these public-
sector institutions, it is their founding legislation that
describes the regulatory arrangements. Accordingly,
there is no external monitoring and supervision by the
Financial Services Board or the Bank Supervision
Department of the SA Reserve Bank for such
institutions. Moreover, incentive contracts with such
institutions are unknown, neither are these institutions
subjected to market discipline, structured early
intervention arrangements or corporate governance
rules. In essence, these public financial institutions are
autonomous bodies backed, if need be, by the
National Treasury.
In contrast, financial institutions in the private sector
are extensively regulated in South Africa. The rules
and regulations usually operate at four distinct levels.
Firstly, there is the general legislation usually
Financial Regulation in South Africa: Chapter 6
applicable to all companies (such as the Companies
Act). Secondly, financial institutions are subjected to
specific prescriptive legislation applicable only to their
functional business (e.g. the Banks Act). Thirdly, the
respective registrars apply the rules in terms of their
specific directives (e.g. the rules issued in terms of the
Banks Act by the Registrar of Banks). Fourthly, the
industry is bound by the self-imposed rulings of
industry associations (e.g. the Banking Council).
In addition to rules and regulations, the regulatory
authorities impose a monitoring and supervision
regime on private financial institutions (mainly
through the inspectorates of the Financial Services
Board and the Bank Supervision Department).
As financial institutions are increasingly becoming
big, complex and even opaque in their overall risk
exposures, the regulatory authorities are attempting to
take the first steps in the direction of incentive
contracts. For example, banks can now choose
between being capitalised in terms of preset fixed-
capital ratios or in terms of their own in-house value-
at-risk (VaR) models. Obviously, such VaR models
have to be approved, and certain risk parameters in the
model are also set by the authorities (including an
absolute minimum capital level), but after that the
institution itself determines its capital-adequacy level
in terms of its risk profile.
By their nature, private financial institutions are
extensively exposed to the harsh discipline of the
marketplace. The market also monitors financial
institutions and may in future even influence their
capital-adequacy requirement. It could do so in a
number of ways, for example the credit ratings of
private-sector rating agencies (local and international)
could be used by the authorities as a parameter for
their risk-assessment procedures. Similarly, the stock
market ratings in terms of the price-earnings ratio
could be used for prudential requirements.
Internationally a new trend is developing in which
banks are asked to issue part of their capital as
subordinated (tradable) debt in the bond market. The
interest rate on that debt is then in turn used as a key
parameter in the capital-adequacy regime.
145
 The new provisions in the amendment to the Banks
Act (2000) entail an important first step on the road to
a structured early intervention regime, as for instance,
substandard, doubtful or bad debts50 have to be
impaired against capital by ratios of respectively 20%,
50% and 100%. Last but not least, all financial
institutions in the private sector are subjected to the
corporate governance regime.
The regulatory matrix for financial market
participants (see Table 6.12) is briefly discussed below.
3.2.1 Rules and regulations
Entry and standards constraints
In order to ensure a sound business infrastructure, all
financial institutions (at least those in the private sector)
have to fulfil the general requirements of the
Companies Act, the Inspection of Financial Institutions
Act,51 the Financial Institutions (Investment of Funds)
Act,52 or the Co-operatives Act (if applicable). All these
Acts endeavour to ensure that a public company meets
the requirements with regard to directors, management,
financial procedures, accountability, etc. In addition
there are the specific requirements of the Banks Act,
the Long-term and Short-term Insurers Acts, the
Pension Funds Act, the Friendly Societies Act, the
Unit Trusts Control Act or the Participation Bonds
Act. These specific Acts set out in great detail the
minimum entry and standards requirements. Moreover,
each of these Acts provides for a Registrar who can
issue additional directives to ensure that minimum
standards are met in respect of institutional soundness
and “suitable” directors, management and systems.
Ownership constraints
Particularly during the last two decades, the
development of global financial conglomerates has
resulted in a more liberal view by the authorities about
ownership constraints. Internationally the trend is to
lift any ownership constraints on foreigners and/or
50
Bank loans are considered bad if the loan becomes uncollectable.
51
In contrast to all other financial institutions, banks are not
subjected to this Act.
52
Banks are subjected to this Act only in respect of their trust
goods.
146
competitors. This trend is also visible in South Africa.
For example the Big Bang on the JSE removed the
requirement that exchange members had to be South
African nationals.53
Nonetheless a number of important constraints are
still on the law books. Insurers may not own more than
49% of a specific banking institution without the
approval of the Registrar of Banks, and a person cannot
hold an interest in excess of 25% in any insurance
company without the approval of the Registrar of
Insurance. Moreover, the names of intended
shareholders in a bank have to be registered (implying
that covert ownership is illegal), and the Registrar of
Banks or the Minister of Finance has to give approval
if a shareholder of a bank has shares exceeding a
certain percentage of the total shares issued.
In case of foreign-exchange brokers, the owner has
to be a South African company registered in terms of
the Companies Act. Non-resident companies are not
allowed to be foreign-exchange brokers. By virtue of
the requirement that the foreign-exchange broker has
to be independent of an authorised dealer, it follows
that a bank may not have ownership interests in a
foreign-exchange broker.
Functional activity constraints
Demarcation lines between the various types of financial
institutions used to be drawn fairly sharply in South
Africa. The aim of restricting the activities of specific
financial institutions to specific functions was to promote
competitive neutrality between functionally different
institutions, or to avoid “excessive” competition
(whatever this may mean today). Ideally, functional
constraints should allow for a more focused approach to
business. However, these demarcation lines are now
increasingly fading in a financial conglomerate.54
In terms of the Banks Act, a bank is restricted in its
business to the taking of deposits and the making of
loans and investments. The Long-term Insurance Act
limits the business of long-term insurers to the issuing
53
The fact that even permanent residents were barred from the JSE
prior to 1995 was of course plainly a trade restriction.
54
However, in a universal bank, the banking and insurance
businesses may still be strictly ring-fenced.
Financial Regulation in South Africa: Chapter 6
 Table 6.12: Regulatory matrix: Financial market participants
Institutional safety and
Regulatory ultimate objectives Systemic stability Consumer protection
soundness

Regulatory
intermediate goals

liquidity
fairness
schemes

neutrality
disclosure

Proper risk
retail funds

assessment
Competitive
Integrity and
Competence
Protection of

infrastructure
infrastructure
Fit and proper
Access to retail

competitiveness
competitiveness

Financial Regulation in South Africa: Chapter 6

Sufficient market
financial services

market exposures
Acceptable cross-
Transparency and

directors and staff

Global institutional

Proper institutional

Competitive market
Retail compensation

currency mismatches
Securities markets as
Regulatory regime and

efficiency and economy

Acceptable maturity and

Regulatory effectiveness,
Adequate product/service

its instruments

alternative to intermediation
1. Official rules and regulations
1.1 Entry and standards constraints X X X X X X X X X
1.2 Ownership constraints X
1.3 Functional activity constraints X X X
1.4 Jurisdictional constraints X X
1.5 Pricing constraints X
1.6 Operational constraints X X X X X X X X X X

2 Official monitoring and supervision X X X X X X X X

3. Intervention and sanctions X X X X X X X

4. Incentive contracts and structures X X X X X X X X X

5. Market monitoring and discipline X X X X X X X X X X X X

6. Corporate governance X X X X X X X X

7. Discipline/accountability of
X X X
regulators

147
of long-term policies (e.g. life-assurance policies,
endowment policies and retirement annuities) – with a
strict demarcation being applied between such
assurance business and other business of a long-term
assurer. Moreover, the Registrar of Insurers may
impose restrictions on the business of issuing policies
and may prohibit the removal of certain assets from
the country. Accordingly, insurers may only issue
specific financial instruments, such as endowment
policies, whereas only banks may create NCDs.
However, an endowment policy of, say, one day
becomes de facto a deposit, and a one-year fixed
deposit can be simulated perfectly by option contracts
in the derivative markets. In essence, financial
engineering is undermining this functional
demarcation, a process aggravated by the development
of multi-product financial conglomerates.
Likewise the Short-term Insurance Act limits the
business of a short-term insurer to short-term
business, i.e. the issuing of indemnity-type insurance
policies. And again, the Registrar of Insurance may
impose additional restrictions on the business of
issuing policies. In a similar way the activities of
reinsurers, medical aid schemes, pension funds,
friendly societies, fund managers, unit trust schemes,
participation mortgage bond schemes and trustees are
functionally constrained.
Finally, in terms of the National Payment System Act,
only banks or their agents may process payment
instructions and only banks may settle payment
obligations across accounts held at the SA Reserve Bank.
The aim of this constraint is to achieve a high level of
payment system integrity and reduce systemic risk.
Jurisdictional constraints
This field of legislation is dominated by the Currency
and Exchange Act, which subjects any cross-border
financial transactions to exchange controls. The
ultimate aim of exchange control is to protect the
country’s currency, and by implication its foreign-
exchange reserves. The requirement that certain
financial institutions must maintain a covered position
(i.e. local currency liabilities have to be covered with
local currency assets) is primarily a prudential
148
requirement (namely the elimination of currency risk),
but is used simultaneously as a tool to avoid unwanted
capital outflows.
Exchange control stipulates that only banks can be
authorised dealers in foreign exchange, and that
foreign-exchange brokers are not permitted to
conduct any business other than foreign-exchange
broking. The Banks Act restricts the business of
deposit taking to South Africa, with special
provisions in place that provide scope for the
establishment of subsidiaries outside South Africa as
well as for the establishment of representative offices
of foreign banks inside the country.
Likewise, insurers are subjected to exchange control,
particularly in respect of cross-border insurance
premiums and benefit payments as well as their
offshore investment holdings. Moreover, the prudential
requirements of the Insurance Act and the Pension
Funds Act stipulate a covered domestic position of 85%
for such institutions.
The stated policy of the Minister of Finance is to relax
exchange control regulations gradually in the years to
come. Accordingly, the covered domestic position
requirements may well be reduced further in future.
Pricing constraints
The pricing of financial products and services is, with
only a few exceptions, unconstrained in South Africa.
The exceptions are the Usury Act, which limits the
financial charge rates to a maximum of 25% p.a.
generally, or ten times the prime rate for specific
industries such as microlenders, as well as the
commission fees of insurance brokers.
As banks’ lending rates are usually well below the
ceiling rate set by the Usury Act, this Act applies
mainly to microlenders and related types of non-bank
business. It is expected that the commissions payable
to insurance brokers will be fully deregulated during
2001. A bill in this respect is likely to go before
Parliament towards the end of 2000.
Operational constraints
Operational constraints usually fall into two major
categories: prudential requirements and market
business conduct requirements. Once again, these
Financial Regulation in South Africa: Chapter 6
requirements can be imposed in terms of general
legislation, specific legislation, external agency
regulation, self-regulation, self-imposed regulation or
moral suasion.
General legislation. The most important Acts are the
Credit Agreements Act (which compels banks to follow
the prescriptions on credit agreements); the Harmful
Business Practices Act (financial activities should be so
conducted as to meet the restrictions under the statue);
the Maintenance and Promotion of Competition Act
(which prohibits cartel arrangements that affect pricing);
and the Insider Trading Act (which prohibits insiders
from profiting by trading on insider knowledge).
Specific legislation. At this next level there are
specific Acts applicable to specific types of financial
institutions. Usually these Acts prescribe in detail the
minimum capital and liquidity requirements, and guide
institutions on conducting their business in a desired
manner and on desisting from certain practices and/or
actions (see Diagram 6.8). For example, insurers may
not pledge or encumber their assets, whereas unit
trusts must be sold for cash (with restrictions being

Diagram 6.8: Operational constraints placed on market participants (expected structure in 2001)

Institutional regulation of capital-adequacy standards

Capital-adequacy standards Capital-adequacy standards Capital-adequacy standards

in terms of in terms of the Insurance, in terms of
the Banks Act Pension Fund and Unit Trust Acts the Investment Services Act*

Registrar of Banks Registrar of Insurance/ Registrar of Financial Markets

Pension Funds/Unit Trusts

Banks Insurers/Pension funds Investment firms

Unit trusts

Functional regulation of market activity

OTC Central securities Regulated

markets depositories exchanges

Self imposed trading rules Authorised rulebooks

Money and Forex OTC BESA JSE SAFEX

capital market market derivatives members members members
participants participants market
participants

* This Act will probably be promulgated in 2001.

Financial Regulation in South Africa: Chapter 6 149

imposed on loans against security of units). The most
important pieces of specific institutional legislation are
the following acts: the Banks Act, the Mutual Banks
Act,55 the Long and Short-term Insurance Acts, the
Pension Funds Act, the Friendly Societies Act, the
Unit Trusts Control Act, the Participation Bonds Act,
the Financial Institutions (Investment of Funds) Act
and the National Payment System Act. Diagram 6.8
sketches the expected supervisory structure divorcing
institutional regulation from functional market activity
in respect of capital-adequacy rules. In terms of the
existing Safe Deposit of Securities Act and the
(proposed) Investment Services Act, a central
securities depository is supervised in a similar vein to
exchanges (and accordingly has to be licensed). The
proposed Investment Services Act will eventually set
the capital-adequacy standards for all investment
firms. However, for the time being the Investment
Services Act only tries to consolidate the Financial
Markets Control Act, the Stock Exchanges Control
Act, the Custody and Administration of Securities Act,
the Insider Trading Act and specific sections of the
Companies Act (particularly those dealing with public
interest, the transfer of shares, debentures and
prospectuses), but ultimately the Investment Services
Act should also cover the capital requirements for
investment firms operating solely in the OTC markets.
The institutional and functional aspects of regulation
are co-ordinated by the Policy Board for Financial
Services and Regulation for all financial institutions
and markets (see Diagram 6.9). The issue of whether
the Financial Services Board (FSB) and the Bank
Supervision Department (BSD) should merge into a
larger single regulatory authority (like the Financial
Services Authority in the UK) has not been finally
resolved in South Africa. The Melamet Committee
(1993) recommended the consolidation of the Offices
of the Executive Officer of the Financial Services
55
The Mutual Banks Act (1993) is similar to the Banks Act (1990)
but differs on two points: firstly, a mutual bank is of course
exempted from the requirement that a bank has to be a limited
company; and secondly, its minimum capital requirements is R50
million, whereas for banks this requirement is going to be
increased to R250 million.
150
Board and the Registrar of Banks at some stage in
future in order to strengthen the holistic approach to
financial regulation in South Africa. In 1999 a Round
Table Conference consisting of the Minister of
Finance, the executives of the FSB and the BSD, as
well as foreign experts, reaffirmed this conclusion, but
to date no concrete steps have been taken to implement
these recommendations.
External agency regulation emanates from specific
legislation and allows the registrars of these Acts to set
additional constraints. The registrars have the statutory
power to issue guidelines (in the form of circulars as to
how the provisions of the Acts are to be applied and
interpreted) and directives based on the provisions of
the Acts for certain (more detailed) activities and how
these are to be conducted.
Self-regulation. Self-regulatory authorities are unknown
for financial institutions in South Africa (except those,
like the JSE, found in the regulated markets).
Self-imposed regulation. Industry associations such
as the Banking Council or the Life Offices Association
(LOA), impose binding rules on their members.
Usually these constraints are in the area of codes of
conduct, advertising rules and sponsorship rules.
However, the insurance industry is generally more
prescriptive with its members than other industry
associations. For example the LOA issues quite
detailed operational constraints with rulings such as
the Benefit Illustration Agreement, Dread Disease
Benefits, Deferred Compensation Policy, and various
registries (e.g. in respect of life, intermediaries and
claims). Likewise, the South African Insurance
Association lays down operational constraints for its
members, such as the Earthquake Agreement, the SA
Knock-for-knock Agreement, the Application of pro
rata Average Agreement, or the War and Civil Risks
Agreement. The reinsurance industry in turn is
constrained by the following self-imposed rules:
reinsurance may not be for a greater amount or for a
longer period than the original insurance; and the
original insurance cannot be altered without the
consent of the reinsurer.
Moral suasion is seldom used nowadays as a
Financial Regulation in South Africa: Chapter 6
regulatory instrument. In the past the governors of the
central bank were not too shy to urge (which
necessarily contains an element of compulsion)
banking institutions to conduct business in a desired
manner. However, with the emergence of global banks
and financial conglomerates, moral suasion has lost
most of its powers and influence.
3.2.2 Official monitoring and supervision
All financial institutions in South Africa are monitored
and supervised by their respective registrars in terms
of prudential and code-of-conduct requirements. This
supervision is increasingly performed according to
minimum international standards (see Chapter 4,
Section 3.2).
3.2.3 Intervention and sanctions
Structured Early Intervention and Resolution measures
were introduced into the regulations of the Banks Act in
2000. Today banks have to impair their capital as per a
provision matrix which defines the status of their loans.
Of course, market manipulation, insider trading, unfair
trading practices and money laundering are criminal
offences in South Africa, and the sanctions thereon are
sufficiently stiff to at least discourage such practices.
Moreover, in 2000 the Financial Stability Unit was
established at the SA Reserve Bank and is aimed at
addressing all issues of systemic risk management,
including structured early intervention rules, the timely
closure of insolvent financial institutions and the
replacement of those directors and senior staff who

Diagram 6.9: Statutory regulation of financial intermediaries and advisers

indicates advisory functions

Minister of Finance indicates executive functions

Policy Board for Financial

Services and Regulation

Department of Financial Services Advisory South African

Trade and Industry Board Committees Reserve Bank

Banks

Office of the Office of the Financial markets Office of the

Registrar of Executive Officer Long-term insurers Registrar of
Companies and Registrar of Short-term insurers Banks
Financial Institutions* Pension funds
Unit trusts

Appeal Boards

Insurers Financial markets: Unit trusts Financial advisors Banks

Pension funds BESA Participation bond
Friendly societies JSE managers
SAFEX Portfolio managers

* The Office of the Registrar of Financial Institutions encompasses the registrars of all non-bank financial institutions, i.e. the Registrars of: Stock
Exchanges; Financial Markets; Insurers; Pension Funds; Unit Trusts and Friendly Societies.
Responsibilities under the Usury Act lie with the Department of Trade and Industry. Responsibilities under the National Payment System Act lie
with the SA Reserve Bank.

Financial Regulation in South Africa: Chapter 6 151

proved plainly unfit for their positions. Much work
still has to be done in this area of regulation
(particularly for non-bank financial institutions) and no
concrete visible results should be expected within the
next few years.
3.2.4 Incentive contracts and structures
This important segment of the regulatory regime is
still relatively underdeveloped in South Africa.
Incentive contracts are currently written between the
regulator and the regulated in two areas, namely in
compliance and risk management for banks.
In terms of the regulations of the Banks Act,
banking institutions have to appoint a compliance
officer, but every bank is free to compile its own
compliance manual which has to be approved by the
board of directors and the registrar. This compliance
manual is likely to be significantly more complex and
detailed for a banking conglomerate than for, say, a
mutual bank. Accordingly the compliance manual can
be viewed as a type of incentive contract, which is
more or less tailored for the specific firm.
A bank can also elect to evaluate its risk exposures
by means of its own value-at-risk models (VaR),
provided such models are approved by the Bank
Supervision Department. The advantage of the VaR
modelling approach is that banking firms can use their
own in-house models and data to measure risks (rather
than use the fixed capital ratios embodied in the
regulations of the Banks Act). The aim is again to
avoid “one size fits all” capital requirements for
fundamentally different type of banks. It is expected
that in future even more emphasis will be placed on
“contract banking”56 particularly in respect of complex
bank conglomerate structures.
3.2.5 Market monitoring and discipline
Ultimately, competitive forces ensure that only the
most effective and cost-efficient financial institutions
56
In “contract banking” a bank defines the components of the services
it wishes to offer and decides which are to be supplied internally and
which subcontracted. In effect, a series of contracts is established by
a contracting bank with internal and external suppliers.
152
survive. Sooner or later weak firms are taken over by
stronger institutions or forced to close down. This
“market law of the survival of the fittest” supports the
stability of the financial system, provided the
(unavoidable) bankruptcies are not themselves
systemic in nature. From a regulatory point of view, the
prudential requirements should never be so stringent
that they eliminate bank failures under all possible
circumstances, as such a cost-inefficient regulatory
regime would be bound to eliminate all possible forms
of financial innovation and in addition make the cost of
credit too high for optimal economic growth.
Today the international approach emphasises that
financial regulation should actively support
competition, but this trend is still relatively
undeveloped in South Africa. In part this is because of
two important factors. Firstly, during the years of
financial isolation (until 1994) foreign product
providers were viewed with suspicion, while local
producers were expected to serve the “national
interest”. Secondly, in South Africa financial legislation
was always highly functional in nature. Financial
conglomerates, operating in many different functions
simultaneously in both the local and foreign markets,
were unknown until the 1990s in South Africa. As a
result the South African regulators were exposed to all
types of unwanted “captures”, particularly in functional
“border disputes” between banks and insurers, or
between local and foreign institutions.
Generally consumers and investors want ever-
greater choice, which in turn entails competitive
choices. So long as the interests of the consumer are
not endangered and provided that no excessive
systemic risks are created, the regulatory authorities
should in principle actively support competition
between local and foreign firms and between the
various markets. By not doing so, the financial system
could be seriously impaired (as the healthy impact of
competition on effectiveness and cost-efficiency
would be weakened).
Internationally acceptable minimum standards can
be introduced by (gradually) opening the markets to
international competition. Therefore existing rules and
Financial Regulation in South Africa: Chapter 6
regulations should be carefully checked for any
(unintended) restrictive and anti-competitive
mechanisms57. Competition policy will also be
enhanced by focused disclosure and transparency
arrangements hand in hand with consumer and
investor education programmes. Last but not least,
entry barriers to the industry should be lowered
wherever possible so as to promote competition.
The transition from a regulatory approach that
confronts “excessive” competition to one that
powerfully supports such foreign and inter-industry
competition will not be an easy one, neither can it be
done overnight. However, if South Africa wants to
retain the quality of its financial services, it has little
choice but to give serious attention to letting market
disciplines work in favour of the ultimate objectives of
regulation. For example in respect of banks, the
capital-market could increasingly be used as a rating
agency. The major advantage of such a regulatory
measure is that private financial institutions have to
prove their quality first and foremost to the markets,
while the regulatory authorities will also obtain
valuable insights from this market evaluation process.
Moreover, it is always difficult for the authorities to
replace unsuitable directors once they are fully
established. Here, too, market forces could be of great
help to the authorities.
3.2.6 Corporate governance
Usually the operational constraints imposed by the
regulatory authorities are blended with corporate
governance requirements. Again, acceptable
international standards are crucial here, as a lack of
corporate governance deters foreign investors.
57
For instance, foreign banks may currently only accept deposits in
excess of R1 million.
Financial Regulation in South Africa: Chapter 6
Accordingly, corporate governance not only improves
the integrity and transparency of financial institutions
and markets, but also powerfully supports market
stability, liquidity and international competitiveness.
Some of the major issues in corporate governance
that still have to be addressed in South Africa are the
following:
• Pyramid companies and non-voting shares (which
makes potential misuse by the major shareholders
all too easy).
• Disclosure rules (e.g. on executive remuneration –
particularly share-option schemes).
• Related-party transactions and exposures.
• Segmental corporate reporting (e.g. geographic and
business segments).
• Capacity to investigate and prosecute commercial
crimes.
3.2.7 Discipline on and accountability of
financial regulators
On this topic, one can be fairly brief. In South Africa
there are currently no effective rules which can
discipline the regulators, neither are there routine
procedures on public accountability. Of course, gross
misconduct will ultimately be disciplined by Parliament,
but more refined methods still have to be worked out. It
is likely that South Africa will follow international
trends in this respect, rather than initiate them.
Currently, exchange members and persons aggrieved
by a decision of the exchange’s governing committees
can take such decisions on appeal to the Appeal
Tribunal established in terms of the FMCA and SECA.
Decisions of the Registrar can be similarly taken on
review. The introduction, in due course, of the
“ombudsman” under the Investment Services Act will
be a further review mechanism strengthening the
accountability process.
153
 Chapter 7
ASSESSMENT OF THE FINANCIAL REGULATORY REGIME IN
SOUTH AFRICA
1. Introduction
The boom in the global financial industry over the past
few decades has been fuelled by an explosive
combination of economic growth, demographic changes,
technology and financial innovation. In this rapidly
changing world1 the optimal alignment of regulatory
instruments has become a complex and highly dynamic
process. Not surprisingly, even tested approaches to
standard regulatory challenges now require some serious
reconsideration. Indeed, “change is the only constant”.
Not only South Africa, but also the industrialised
countries are faced with fundamental changes in their
socio-economic environment. For example, the following
structural changes are evident: the decreasing powers of
the national state in a world consisting of offshore
financial centres2 and “e-citizens”; the attainment of the
upper limits of the social welfare state; pressures for
lower (global) taxes and thus a smaller state; the massive
migration of refugees from one nation to another; and the
ageing of the population in the West. In the South African
context the socio-economic challenges may even be
greater than those faced in the industrialised countries,
because of the country’s underlying dualistic nature3 and
the problems caused by nearly half the population being
undereducated, and as such unemployable, in what are
today known as the “knowledge economies”.
Section 2 emphasises the evolutionary trends in
1
The shape of financial markets is set by factors such as financial
engineering, computer technology, e-commerce, volatile inter-
national capital flows and powerful global financial conglomerates.
2
“By some estimates more than half of the world’s stock of money
passes through offshore centres, about 20% of total private
wealth is invested in those centres and about 22% of banks’
external assets are invested offshore.” See Francis, J. “The
Bahamas perspective”, in The Financial Regulator, Vol. 4, No. 4,
London: Central Bank Publications, 2000, p. 27.
3
As reflected, for instance, in a highly sophisticated financial
sector in what is basically a lower-income developing country.
154
South African financial regulation. In this section the
following basic questions are posed: “What is so
different today on the regulatory front compared with,
say, a decade or two ago? And what is to be expected
in regulation during the next decade?” To address such
issues an effort is made to identify the engines of socio-
political change and to evaluate, against this
background, whether the use of the regulatory
instruments was appropriate. The projection of the
South African economy during the next decade is
based on a supply-driven econometric model that
ultimately is driven by available production factors
such as fixed capital stock, skilled labour and multi-
factor productivity. Thereafter, a rough guess is made
to see whether the financial system is able to confront
these economic challenges with a degree of confidence.
Against the socio-economic background of Section 2,
Section 3 attempts to identify existing regulatory gaps,
and thus set the regulatory targets,4 in the current
financial system. The emphasis is on three issues,
namely institutions, markets and infrastructure. The
last section sets out a few possible guidelines for the
South African regulatory regime in the years ahead.
2. The evolutionary trends in South
African financial regulation
Regulation takes place in a specific socio-economic
environment. Although it is not the aim of this section
to sketch in any detail the socio-political developments
of the past, nonetheless note has to be taken of this
environment in the overall assessment process.
Accordingly, a short summary is first given of the
socio-economic background, and then the regulatory
issues are addressed in greater detail.
4
Regulatory targets are usually aimed at improving the regulatory
instruments – irrespective of whether the authorities or the
markets use these instruments.
Financial Regulation in South Africa: Chapter 7
2.1 The socio-economic environment
during the past few decades and
prospects for the next decade
Table 7.1 summarises some of the key variables and
characteristics of the South African economy and the
role that the financial sector plays in it. The aim of the
table is not to present yet another economic projection.
The aim is rather to present a conservative scenario,
which highlights possible future trends and emphasises
some of the major constraints placed on the economy.
Obviously, the scenario presented may prove
unrealistic, but from a planning point of view “stress
testing” of the regulatory environment has to be done.
The scenario assumes world economic growth of some
two per cent per annum and stable terms of trade for
South Africa. The following remarks can be made:
• Demographic developments: After the population
had grown at an average rate of 2,3% p.a. during
the past two decades, it is expected to flatten out
from 2007 onwards. The population may even fall
from 2010 onwards, mainly owing to the impact of
diseases (e.g. Aids, TB and malaria), as well as
better birth-control measures. In fact, during the
next 15 years some 12 million people may die from
Aids and the population is likely to peak at some
50 million at the end of this decade. The average
life expectancy of South Africans may even drop to
a mere 40 years by 2015. The financial sector will
be affected in a number of ways as a result. For
instance, retail banks may experience no real
growth in credit extension, bad debts on mortgage
finance may rise sharply (another consequence of
Aids), and there may also be major claims on
medical aid schemes and insurance in general. The
term structure of the banks’ loan books is likely to
become shorter, which may have an adverse effect
on long-term fixed investments.
• Households: Without any material increase in real
savings, households will struggle to reduce their
debt to more acceptable levels. The impact of Aids
will make this reduction even more difficult.
People will spend less on normal consumption
items, but significantly more on health care. Being
Financial Regulation in South Africa: Chapter 7
already heavily taxed, households are expected to
make no material contribution to the national
savings and thus fixed investments in the
foreseeable future. At best they will remain neutral,
even though this sector accounts for as much as 63
per cent of GDP. In this environment it will be very
difficult for the government to encourage
microlending to disadvantaged communities.
• Corporate sector: This sector is likely to be the sole
engine of economic growth in the immediate future.
To support long-term economic growth of say some
1,5 per cent per annum, the nation’s gross capital
formation has to be some 18 percent of GDP (it is
currently around 16 per cent). Net foreign capital
inflows have financed about 15 per cent of South
Africa’s gross capital formation since the end of
1994 and, on the basis of net capital formation5,
they amounted to over 70 per cent. This
dependence on foreign savings to finance local
investments will remain the Achilles heel of the
South African economy until the government and
private households start saving seriously again. For
a relatively open economy6 such as South Africa,
import protection has progressively fallen away in
recent years. Moreover, in the years ahead, as Aids
takes its toll, the corporate sector may have to rely
increasingly on highly skilled, imported labour
(particularly in the securities markets). Although
profit margins in corporate banking are already
thin, competition in this sector is likely to remain
stiff as foreign banks may start to operate more
aggressively in this market segment. A shakeout of
cost-inefficient banks is to be expected in future,
which in turn may require the involvement of the
central bank in a number of ways.
• Government sector: The finances of the state are
overstretched on nearly all fronts, as reflected in
the general government’s dissaving since the early
1980s. From the government’s point of view, its
5
Net capital formation is equal to gross capital formation minus
the depreciation of existing capital stock.
6
Total imports and exports account for around half of the
nation’s output.
155
 Table 7.1: Socio-economic indicators of the South African economy
Demographics
1980-1989 1990-1994 1995-1999 2000-2004 2005-2015
Birth rate %change pa 3,0% 2,9% 2,7% 2,4% 2,1%
Death rate % change pa 0,9% 0,8% 1,0% 1,6% 2,4%
Aids deaths number pa - 10 231 105 650 426 846 828 488
Normal death number pa 284 926 305 600 323 571 337 440 344 096
Total population millions 32,4 35,8 39,9 45,4 50,5
Total population growth % change pa 2,5 2,3 2,2 1,8 0,9
Labour market
1980-1989 1990-1994 1995-1999 2000-2004 2005-2015
Highly skilled labour/total employment ratio % 10,2 12,7 14,3 16,0 17,5
Highly skilled labour/total employment ratio % change pa 3,2 2,1 3,0 1,6 1,0
Real output per worker % change pa 0,7 1,5 3,7 1,5 1,5
Real wages % change pa 1,0 0,8 3,8 1,5 1,5
Capital/labour ratio % change pa 1,9 2,1 3,4 2,0 2,4
Total labour force growth % change pa 2,6 2,6 2,7 2,5 2,3
Unemployment rate % 24,1 33,3 39,6 42,8 41,6
Saving
1980-1989 1990-1994 1995-1999 2000-2004 2005-2015
Net household saving/disposable income % 5,9 3,1 1,2 0,7 1,3
Net corporate saving/corporate profits % 23,3 24,0 19,8 16,9 15,8
Net government saving/government revenue % -8,5 -21,0 -14,8 -9,8 -9,4
Total gross domestic saving/GDP % 23,5 17,3 15,1 15,2 16,4
Fixed investment
1980-1989 1990-1994 1995-1999 2000-2004 2005-2015
Gross fixed capital formation % change pa -3,6 -1,7 3,0 3,7 1,9
Gross fixed capital formation/GDP % 21,8 16,1 15,9 16,1 17,9
Net capital formation/GDP % 6,0 1,7 3,5 3,6 4,5
Real capital stock % change pa 2,5 0,6 1,6 1,9 2,0
Gross foreign direct investment/GFCF % - 0,8 6,9 7,0 5,5
Net foreign direct investment/GFCF % 0,0 -3,1 -0,7 -0,5 -1,0
Net capital inflow/net capital formation % -21,5 -48,5 70,7 31,3 15,9
Net capital inflow/gross capital formation % -5,8 -5,2 15,0 7,0 4,0
Debt exposures
1980-1989 1990-1994 1995-1999 2000-2004 2005-2015
Household debt/disposable income % 47,4 52,5 59,7 58,3 57,8
Government debt/GDP % 33,0 42,0 49,2 52,9 60,9
Foreign debt (non-monetary private sector)/GDP % 6,2 (85-89) 3,8 5,0 6,0 7,5
Foreign debt/export earnings % 100 (85-89) 91,0 102,7 105 108
Output
1980-1989 1990-1994 1995-1999 2000-2004 2005-2015
Actual GDP growth % change pa 1,4 0,2 2,0 1,3 1,1
Potential GDP growth % change pa 1,5 1,5 2,0 2,0 1,5
Government sector
1980-1989 1990-1994 1995-1999 2000-2004 2005-2015
Total government consumption expenditure/current income % 73,7 79,0 73,4 72,5 73,8
Total government fixed investment/GFCF % 6,9 13,9 11,9 12,2 12,0
Total taxes/GDP % 22,2 24,1 25,2 25,9 25,7
Total tax on imported goods and services total/imports % 7,8 8,7 4,8 4,2 4,5
Monetary sector
1980-1989 1990-1994 1995-1999 2000-2004 2005-2015
Real prime rate % 1,6 5,8 11,3 8,6 7,9
Real effective exchange rate % change pa -0,7 2,1 -4,2 -1,9 -1,0
Real domestic credit extension % change pa 2,0 0,4 7,8 1,0 1,0
Headline inflation rate % change pa 14,7 11,9 7,2 5,2 5,5
Financial sector
1980-1989 1990-1994 1995-1999 2000-2004 2005-2015
Real financial sector output/GDP % 14,8 16,1 17,2 17,5 17,0
Real financial sector capital formation/GFCF % 21,6 22,9 23,1 23,5 23,0
Financial sector imports/total imports % 6,0 3,7 3,0 3,2 3,0
Note: GFCF = Gross fixed capital formation

156 Financial Regulation in South Africa: Chapter 7

 major concern remains the possibility of a fiscal
debt trap. Although the structure of government
finances has improved materially since the mid-
1990s, the impact on government debt of a
structurally lower inflation rate and a more
competitive open economy has not yet fully
worked through the public accounts. Because
government has committed itself to a high level of
consumption expenditure for socio-political
reasons, virtually no funds remain for public fixed
investments. Privatisation is one possible solution
in this context. Although the level of government
debt is currently not too far out of line with
international standards, the interest costs of
servicing this debt are nonetheless placing a severe
burden on the state’s finances. The management of
government debt will be a major challenge in the
years ahead.
• Total economic output: The sustainable growth rate
of real output of the South African economy is
likely to be some 1,5 per cent per annum for the
medium term. This relatively low growth rate is
due to the impact of Aids, a low level of fixed
investments, the scarcity of highly skilled labour
and relatively low productivity. In this depressed
macroeconomic environment, the financial sector
may try to support its historical growth
performance by progressively investing abroad.
This scenario implies that local financial
institutions would aim to become global
conglomerates, which in turn would have some
major consequences for local regulators.
2.2 The regulatory regime in the 1980s
The 1980s were a period when the first hesitant steps
were taken by the authorities to free the economy from
over-regulation. A generation ago the regulatory world
was quite different from what it is today. For instance,
during that period: regulators hardly looked beyond
the national frontiers (despite rapid growth in cross-
border business); capital requirements were based on
simple gearing ratios of capital to total assets; off-
balance-sheet items were virtually disregarded
Financial Regulation in South Africa: Chapter 7
(derivatives were unheard of); consolidated supervision
was an unknown concept; country risk was little
heeded (because “countries don’t go bust”); the
financial sector components – banks, insurance and the
capital markets – were regarded as separate species
nationally; regulators seldom spoke to one another;
international contacts were just beginning; and
supervisory co-operation at an international level (not
to mention co-ordination or standardisation) was still
only a pipe dream7.
Owing to its politically isolated position, South
Africa followed these international trends rather
sluggishly in the 1980s. In fact, co-operation with
foreign regulators was nearly non-existent, and as a
result the regulatory structure became progressively out
of line with international best standards. In South
Africa, the process of deregulation only started to gain
momentum in the 1990s. These local developments
will be analysed now by looking at the three pillars of
the financial system in somewhat greater detail, namely
financial institutions, markets and infrastructure.
2.2.1 Financial institutions
The true forces of competition arrived only recently in
the South African financial sector. For instance, banks
have started to compete on price (i.e. interest rates)
only since early 1983 (i.e. with the abolishment of the
Register of Co-operation). Building societies had
favourable funding benefits from the government that
effectively resulted in controlled lending and deposit
rates until the mid-1980s. Price competition between
banks and building societies started in earnest on the
asset side on their balance sheets in 1984 (when
Standard Bank came into the bond market) and on the
liability side in 1998 when the phasing-out of the tax
privileges on building societies “shares” began8. A
level playing field between banks and building
7
Cooke, P., “The future of financial regulation”, The Financial
Regulator, Vol. 4, No.1, London: Central Banking Publications,
1999, p. 23.
8
Building societies were immediately forced to start competing on
a level playing field for deposit funding, even though they
continued to benefit from the endowment factor of the tax-
privileged share funding for another 5 years.
157
societies materialised only with the Deposit-taking
Institutions Act of 1990 (renamed the Banks Act in
1996). Money-market funds were not yet available as
an alternative to bank deposits.
Owing to South Africa’s politically isolated position
until 1994, competition from foreign banks was very
limited in the 1980s. Foreign banks were exclusively
active in the corporate market, often concentrating
solely on their home clients’ businesses in Africa. In
fact, some of the major overseas shareholders (e.g.
Standard Chartered, Barclays and ABN AMRO)
disinvested their South African bank holdings for
political reasons in the mid-1980s. Local financial
companies picked up these shares cheaply, which
resulted in even higher levels of financial power in the
local market. By 1994 the four largest banks granted
more than 80 per cent of all local credit.
Competition among the long-term insurance
companies was (and still is) limited due to “industry
agreements”. The fiscal aspects of life assurance
contracts were co-ordinated effectively by the Life
Offices Association (LOA). Most insurance companies
and associated bodies toed the line of the LOA in
respect of illustrative values, replacement of life
assurance contracts and disclosure policies. Likewise,
competition between assurance intermediaries (agents
and brokers) was based mainly on the “quality of
services” rendered and only to a limited extent on
price. Insurance commissions paid to intermediaries
are still statutorily capped and not disclosed to the
paying consumer, implying that usually the maximum
commissions are charged.
As the 1970s and 1980s were characterised by low,
and often negative, real interest rates and high
inflation, the insurance industry was in a preferential
competitive position vis-à-vis the banking sector.
Another major factor that benefited insurers was the
preferential tax treatment of income (on the basis that
the insurer was treated and taxed as the “trustee” for
the policyholders). This resulted in an uneven playing
field, and the Sixth Schedule of the Income Tax Act
was subsequently amended in the early 1990s in an
attempt to restore this imbalance (it was eventually
158
replaced by measures in the Insurance Act9).
Moreover, the fiscal regime was particular attractive to
insurers as the government turned a blind eye to the
long-term contractual impact of inflation. This
favourable competitive position of the insurance
industry was reflected in the rapid growth of its market
share during the 1980s.
2.2.2 Securities markets
Seen from an international perspective, the
development of the South African securities and
investment institutions and business was seriously
delayed, mainly because of uneven playing fields for
the various financial institutions. For instance, banks
were in an unfavourable competitive position vis-à-vis
the insurance industry, and the development of the
securities market was effectively constrained by the
lack of competition on the Johannesburg Stock
Exchange (JSE). Price competition on the stock
market only arrived after the Big Bang on the
Johannesburg Stock Exchange in 1995. Prior to this
date, stockbrokers competed solely on their “quality of
service”. They could not trade as principals with their
clients (but could with other brokers) and had to rely
on their limited personal resources for capital
purposes. As a result, stockbroker investment in the
exchange’s trading, clearing and settlement systems
was neglected (which only became particularly evident
towards the end of the 1990s).
Considering all the trading restrictions imposed by the
JSE on its members10 prior to the Big Bang, the opening
of the futures market (SAFEX) in 1989 was a welcome
sign of somewhat greater price competition in the
securities markets. Initially this competition was limited
to futures on equity indexes. Futures on individual
shares had not yet been developed or approved.
In South Africa the bond market started very
9
Insurance companies (long- and short-term) were regulated by
means of a single Act, namely the Insurance Act 27 of 1943. This
act was separated only in 1998 into Long- and Short-term
Insurance Acts.
10
For instance, single-capacity trading, fixed commissions, no
corporate membership, floor trading and unlimited liability
structures.
Financial Regulation in South Africa: Chapter 7
informally and rigidly in the late 1960s when
institutions began purchasing bonds directly from the,
then, Department of Finance (now the National
Treasury). Eskom (the electricity parastatal) started to
make markets in its own stock as well as government
bonds in the late 1980s. Statutorily the JSE was the
only formal bond market until 1996, because bonds
were a form of security as defined in terms of the
Stock Exchanges Control Act, 1985. However, an
active informal bond market existed outside the JSE,
particularly among well-capitalised merchant banks. It
was only in the early 1990s that bond brokers became
proper financial intermediaries between institutions
and the government (and other issuers) in both the
primary and secondary markets. In 1989 the informal
and formal bond markets were combined into the
Bond Market Association (BMA), which in turn was
transformed into a formal exchange, the Bond
Exchange of South Africa (BESA) in 1996.
2.2.3 Financial infrastructure
The financial sector’s infrastructure was rather
rudimentary in the 1980s. Incentive structures between
the regulator and the regulated were unknown at that
time, and transparency and accountability were
generally poorly developed. Industry codes of business
conduct and ombudsmen procedures to address
consumer complaints were established under the
auspices of voluntary industry arrangements in 1985
for life assurance and in 1989 for short-term insurance
respectively, but not for banks and financial advisers.
The disclosure regime in the 1980s clearly left room
for improvement. Banks at that time were not subjected
to certain provisions of the Companies Act, which
implied, for instance, that their (secret) reserves were
not disclosed. With some of the key data missing from
the banks’ balance sheets, the creditworthiness of
banks was difficult for investors to judge. In fact,
creative accounting and the non-reporting of major off-
balance-sheet positions were standard practices in
banking at the time. The disclosure requirements for
insurers were even less demanding. In essence, the
chief actuary, in line with the stipulations of the
Financial Regulation in South Africa: Chapter 7
Insurance Act and LOA policies, took responsibility
for disclosure, and the policy always seemed “the least
said the better”. Last but not least, various corporate
structures – e.g. nominee companies, non-voting shares
and pyramid company structures – obscured ownership
and effective control in South Africa in the 1980s.
At this time, companies were not required to comply
with formal corporate governance rules.
2.3 The regulatory regime in the 1990s
To face the challenges of financial innovation, capital
mobility and global financial conglomerates, the ethos
of regulation changed rapidly after the late 1980s. The
structure of regulation moved strongly in the direction
of deregulation, with significantly more reliance on
market forces. More important was that the consumer
moved more to centre stage and that for the first time
the authorities took consumer protection issues more
seriously. As a result, corporate governance rules,
disclosure, transparency and accountability became
key concepts in regulation.
During this period, international experience was
broadly along the following lines:
• Financial regulators and supervisors started to meet
regularly in national and international groupings;
• national financial regulatory regimes were edging
closer together, producing much greater
international cohesion;
• core principles of supervision for banks were
developed and widely adopted, if not yet
effectively implemented universally, and similar
efforts were made for the capital markets;
• basic concepts for capital-adequacy measures were
agreed upon;
• fundamental concepts of the management of risk and
associated emphasis on effective management control
systems were becoming increasingly accepted as the
cornerstones of supervisory practice; and
• in a world increasingly dominated by complex
international financial groups, supervisors were
striving to devise effective global arrangements.11
11
Cooke, op. cit., p.23.
159
 Until the early 1990s South Africa somewhat lacked
these international developments, but after its political
isolation came to an end in the mid-1990s, the country
quickly adjusted to international standards.
2.3.1 Financial institutions
Today banking in South Africa is a highly competitive
industry. In the span of a decade, with the exception of
the few constraints on foreign banks,12 competitive
constraints on banks have been removed. However,
competition between banks and the securities market is
not yet on a level playing field, owing to a range of
restrictions on the issue of commercial paper and
corporate bonds.13 Despite initial opposition from
the banking industry, money-market funds14 as a
competitive alternative to bank deposits, appeared on
the financial scene in 1997.
During the 1990s not much happened on the
securitisation front in South Africa, but considering
international parallels, the next decade could see some
massive changes. In fact, to encourage the financing of
inter alia housing or small business through the
securities markets, securitisation may be a key concept
in future. Initially the banks resisted securitisation as
their attention was focused on growing their interest
income and holding the assets on their balance sheets.
12
For example, foreign banks may currently not accept deposits of
less than R1 million from the general public.
13
For instance, commercial paper to obtain operating capital may
only be issued by a listed company with net assets exceeding
R100 million. In addition, commercial paper has to be issued in
denominations of R1 million or more, unless –
• the paper is listed on a recognised financial exchange.
• the paper is endorsed by a bank.
• the paper is issued for a period longer than five years.
• the paper is issued or backed by the government.
Moreover, only the following persons may be ultimate borrowers
of the money obtained from the general public against the issue
of commercial paper:
• The issuer.
• Subsidiaries and holding companies of the issuer.
These restrictions make it utterly impossible at present to use the
securities markets as a competitive alternative force for small
business finance.
14
These funds are managed as a subdivision of the unit trust
industry and are today an important section of the market.
160
However, during the second half of the 1990s, banks
started to reassess their policies of holding all assets on
the balance sheet, because of higher capital
requirements (particularly for developing countries),
increased compliance costs in banking, the entry of
new niche and foreign banks, and the need to eliminate
cross-subsidisation to ensure long-term profitability.
The favourable competitive position of the insurance
industry established in the 1980s continued into the
1990s. In 1980 the insurance industry output was 27
per cent of the value added in the financial sector, and
its contribution in 1995 had grown to 42 per cent.
2.3.2 Securities markets
The Big Bang on the Johannesburg Stock Exchange
took place in 1995, heralding price competition,
corporate membership and dual-capacity trading. The
previous lack of stockbroker investment in the
exchange’s trading, clearing and settlement systems
was now evident and even massive investment since
Big Bang has not succeeded in resolving all the
outstanding issues. Even today, settlement on the JSE
is an activity that requires a degree of patience, as it is
carried out on a fixed basis only once a week15.
Compared to the levels of competition faced by
exchanges in the industrialised countries today, South
African securities markets are still sheltered16 against
the competitive gales blowing abroad. Nonetheless,
South African’s exchanges are not immune to foreign
competition. For instance, international participation is
about half of the turnover on SAFEX, and a third on
both the BESA and the JSE. Because the JSE adjusted
so late to international competitive forces, it now trails
behind these international developments, with
shortcomings in its organisational structure (perceived
to be expensive), clearing and settlement systems
(unacceptably out of date) and listing requirements (not
yet fully comparable to international requirements).
15
Settlement is non-contractual and for no fixed date, it takes place
from every Tuesday, but can be extended at times for weeks if
there is any problem with the scrip delivery.
16
Mainly by the protection offered by existing exchange-control
regulations.
Financial Regulation in South Africa: Chapter 7
The situation is exacerbated by a perception of high
transactions costs. Of course, there are reasons for this
state of affairs. For example, the JSE is involved in
expenses that are not faced to the same extent by
SAFEX and the BESA, such as the supervision of
securities firms’ capital-risk adequacy17, an education
programme for the general public18, control systems to
police insider trading (a requirement of the Insider
Trading Act) and the costs of assisting the Securities
Regulation Panel (SRP). Despite its high operating
costs, the JSE will be protected from serious
competition from abroad (or locally) as long as the
securities traded are not fully dematerialised and
foreign-exchange controls remain in place.
During this period, despite strong opposition from
the JSE, the activities of SAFEX were extended to
futures on individual shares in 1997 (although they
only became accepted a few years later). The JSE
successfully countered this shortly afterwards by
introducing warrant instruments on individual shares.
Meanwhile the Bond Market Association established
itself. OTC trading in bonds was phased out slowly
from 1989 and totally eliminated with the formal
implementation of the Bond Exchange of SA (BESA)
in 1996. Prior to licensing, the BESA implemented an
electronic trade matching, clearing and settlement
system (delivery versus payment).
The commercial paper and corporate bond markets
are poorly developed in South Africa, because of the
constraints imposed by the Banks Act (see Section
2.3.1 above). These restrictions could be lifted, in
principle, when Parliament has approved the proposed
Collective Investment Schemes Control Bill, the
Investment Services Bill and the amendments to the
Companies Act. However, in the absence of this
legislation, the Registrar of Banks is hesitant to
deregulate this market, as small investors need
protection against the abuses still possible under
17
For banks the Bank Supervision Department of the SA Reserve
Bank carries this expense. Most securities firms are de facto
supervised in terms of their capital adequacy by the JSE and not
by the BESA or SAFEX or even the FSB.
18
Strictly speaking, public education is not an exchange task – not
even the education of the investing public.
Financial Regulation in South Africa: Chapter 7
current legislation (as was evidenced in the
Masterbond and Supreme Bond debacles during the
early 1990s).
2.3.3 Financial infrastructure
The first corporate governance rules were published by
the King Commission in 1994; risk-based capital
requirements, in line with the EU directives, were
introduced for banks in 1991 and for securities firms in
1995; banks (not other financial institutions!) were
required to report in terms of the generally accepted
accounting rules in 1996; and consolidated accounting
rules for financial conglomerates (and therefore the
avoidance of double counting of regulatory capital)
were made mandatory for banking groups in 2000.
In rapid succession, minimum international standards
were introduced, for example in respect of capital
adequacy, accounting and audit, and disclosure. Of the
25 Core Principles set by the Basel Committee19, South
Africa has implemented today 80 per cent fully and 12
per cent partially, though 8 per cent are not addressed
at all. The outstanding areas are mainly related to items
such as loan classification, concentration within
portfolios, intra-group exposures, country risk
management, money laundering, consolidated
supervision and timely corrective action against banks
which fail to meet prudential requirements (e.g. the
revocation of their banking licences). After the
implementation of the new Regulations under the
Banks Act (probably later in 2000), South Africa will
fulfil some 95 per cent of these Core Principles and
partially fulfil the remaining 5 per cent.
Statutory formalised adjudicator offices were
established during the late 1990s for banks and
pension funds, and draft legislation on the recognition
of voluntary schemes in the insurance industry20 is
currently being prepared.
Despite the initial opposition of the industry, the
19
For details of the principles see the Bank for International
Settlements’ Website at: http://www.bis.org/publ/bcbs30a.htm
20
During the 1990s Short- and Long-term Insurance Ombudsmen
were appointed voluntarily by the respective South African
insurance associations, which pay their remuneration and the
administrative expenses.
161
authorities started to improve the infrastructure of the
insurance industry during the mid-1990s.
Early in 2000, significant progress had already been
made, as reflected inter alia in a detailed disclosure
regime for consumers (i.e. the Policyholder Protection
Rules in accordance with the Long- and Short-term
Insurance Acts). Financial advice and the intermediary
services will be subjected to regulatory requirements
soon (with the promulgation of the Financial Advisory
and Intermediary Services Act expected later in 2001).
Moreover, the development of the different codes of
business conduct and ombudsmen procedures will
become more and more important and could even
become a statutory requirement.21 In fact, South
African insurers today fulfil substantially 13 of the 17
core principles set by the International Association of
Insurance Supervisors (IAIS)22, and partially fulfil the
remaining four core principles. Most of the
shortcomings are in the area of corporate governance,
internal controls, transparency of reinsurance and
conduct of business (i.e. investor protection).
Likewise, major strides were made in the securities
markets by 2000 to improve the financial
infrastructure of markets. All exchanges are moving
towards fully automated trading, clearing and
settlement systems – ideally all seamlessly
interconnected.23 The JSE is undergoing a major
restructuring process, mainly aimed at improving
listings requirements to ensure greater competitiveness
with overseas bourses and better investor protection.
This entails inter alia that listed companies should
comply with generally accepted accounting practices,
more disclosure and transparency, suitability standards
for directors, a rise in the minimum public float, and a
higher and longer profit history before listing will even
21
With the exception of the Pension Funds Adjudicator, none of the
ombudsmen are “statutory”. They are all voluntary and at best
there is a contractual obligation on the institution. In time to come
it is likely that the various industry codes and adjudicators will run
in tandem with the statutory codes of conduct and adjudicators.
22
For detail of the principles see the IAIS’s Website at:
http://www.iaisweb.org/framesets/pas.html
23
Floor trading on the JSE was abolished in 1996 and eventually on
the BESA in 1998.
162
be considered. It is expected that the majority of these
changes will be implemented on the JSE in October
2000. Of the 30 Core Principles of securities
regulation set by IOSCO24, South Africa complied
fully with 24 and partially with 6. Shortcomings were
mainly in the area of investor protection, too much
informal oversight, not enough enforcement powers,
inadequate clearing and settlement systems, and issues
related to financial fraud and money laundering. With
the proclamation of the Financial Advisory and
Intermediary Services Act, South Africa will fulfil all
IOSCO’s Core Principles except for some specific
measures against financial fraud, money laundering
and clearing and settlement standards.
2.4 The expected regulatory regime
in the 2000s
Obviously the future is and will always remain
unknown. Nonetheless an indication of possible future
developments has to be given for regulatory planning
purposes. Based on the projections given in Section 2.1
above, the socio-economic scenario a decade from
today may be rather depressing. Of course, better socio-
economic conditions may materialise in reality, but
regulators are by nature more interested in the downside
potential. The power of “negative” thinking cannot be
ignored in this context25. Accordingly, consideration
must be given to an economic environment dominated
by the impact of Aids, a lack of domestic savings, a
high dependence on foreign capital flows, increased
globalisation of local companies and even greater
poverty among the uneducated part of the population.
The optimal regulatory regime has to be designed
against this background.
Based on current trends in net capital formation, the
supply of highly skilled labour and multi-factor
productivity, the South African economy has an
output growth potential of some 3 per cent per annum
at best. This optimistic scenario assumes no impact
24
For details of the principles see IOSCO’s Website at:
http://www.iosco.org/download/pdf/1998-objectives-eng.pdf
25
Indeed, even luxury ocean-going sailing yachts, exclusively used
for recreation, should be able to withstand gales.
Financial Regulation in South Africa: Chapter 7
from Aids. However, if no affordable defence against,
or cure for, Aids is found, sustainable GDP growth
may be reduced to some 1,5% p.a. by 2005, implying
that actual GDP could be some 10% lower in 2010
than it would have been without Aids. So, within a
decade, the country may be faced not only with a
marginal decline in its population, but also with
stagnant economic output. Moreover, Aids will be
expensive in terms of its opportunity costs. Medical
expenses, lower productivity, sick leave, early
retirement (but with insufficient retirement funds),
and the expensive retraining of new staff (for
relatively short periods) may result in a massive
increase in bankruptcies among small companies that
are by nature highly dependent on a few key persons.
Moreover the social problem of a potential 2 million
orphans will place a heavy burden on the
government’s social expenditure budget. With more
than a quarter of the South African workforce
potentially affected by Aids by 2005, large companies
are likely to soften the blow by greater automation.
As domestic savings are already low, larger
companies will have to rely increasingly on retained
earnings to finance these investments.
As the monetary authorities are inter alia
responsible for systemic stability, the capital-adequacy
rules for financial institutions and other infrastructural
requirements will have to be reconsidered in the light
of all this. To secure the foreign financing of domestic
fixed investments, the authorities have to ensure that
foreign creditors deal with local financial institutions
that are sound and safe, despite all the potential
macroeconomic setbacks. No doubt these prudential
requirements will be harsh for South African financial
institutions, but as the county is so dependent on
foreign finance, the attitude overseas may be more or
less along the lines of “beggars can’t be choosers”.
2.4.1 Financial institutions
In a stagnant economic environment, the existing
socio-economic dichotomy of South African society
may increase even further in the years ahead. In fact,
local financial institutions may follow a similar trend
Financial Regulation in South Africa: Chapter 7
by falling into two broad categories – global
financial conglomerates and specialised local
financial institutions. In future the large South
African banks are bound to become truly complex
financial groups with a sharp international focus to
their business. In South Africa, their main focus is
the corporate and government sectors as well as
relatively wealthy households, but the delivery of
financial services to the poor and small business
sectors may become an “unprofitable sideline”
activity (i.e. mainly for socio-political reasons). With
their corporate clients borrowing and investing
around the globe, banking has become a 24 hour-a-
day business with major trading operations in the
different time zones. Ultimately, these global banks
will cluster in only a few financial centres like
London and New York where they can source the
important parts of their business – particularly their
most skilled and highly priced employees. Business
in Johannesburg may become no more than an
important branch for such South African-owned
global banks. For these institutions, national
boundaries become increasingly unimportant, inter
alia because it is becoming difficult to define a
domestic market (as reflected in for instance remote
trading26). Global banks will be under severe
competitive pressures to reduce costs and thus try to
eliminate cross-subsidisation wherever possible.
By contrast, financial services to the poor in South
Africa are likely to be supplied by more specialised
financial institutions, such as core banks (see Section
3.13 below), mutual banks which specifically foster
community banking and various types of savings co-
operatives27. These institutions are very small
compared to the few large global banks in South
Africa, but have the advantage that they are in much
26
Commercially the distinction between “international” and
“domestic” has disappeared. Only the regulators and the tax
authorities still have to hold on to these concepts, as the state, in
contrast to companies, is dependent upon the taxes it levies.
27
These various legal entities, e.g. village financial services co-
operatives, credit unions, microlenders, start-up venture capital
providers and stokvels all operate on an effective exemption basis
under the Banks Act, 1990 (rather than being legitimised by it).
163
closer contact with their supporting communities28.
Considering the type of lending they are involved in,
their dependence on skilled personnel is far less
critical than for complex financial groups.
The challenges facing the banking industry in the
years ahead seem twofold. Firstly, how to ensure
that the financial sector remains systemically stable
in an environment of rapid technological change and
sharply increased competitive conditions. And
secondly, how to ensure that banking services are
delivered to the broad community which includes
the poor. These challenges entail, in essence, two
conflicting regulatory goals and accordingly
different instruments would have to be used to
address them simultaneously. In Section 3 below,
three specific regulatory targets and regulatory
instruments are proposed in this context: increasing
global competition in the local financial markets
(Section 3.1); the development of the commercial
paper and corporate bond markets in South Africa
(Section 3.5); and the establishment of core banks
(Section 3.13).
2.4.2 Securities markets
Since the securities markets are almost totally
dominated by wholesale transactions, they are
exposed even more than the banks and insurers to the
influences of technology and globalisation. As
technology improves, the competitive position of the
securities markets becomes enhanced virtually
automatically vis-à-vis the traditional financial
intermediaries. And, as exchanges become more
global in nature (typically starting with remote
trading), the competition displays an increasingly
international character. Already South African
securities are traded simultaneously in Johannesburg,
London, New York, Frankfurt and Zurich. The local
bond market is a very liquid market with major
28
A close tie with the local community is extremely important in
the South African context because the government cannot always
ensure law and order in the townships and rural areas. As a
result, the large banks have hesitated to lend in these areas as the
operational risks were considered simply too great.
164
foreign participation. There is a potential, over the
next few years, for new large markets to develop
quickly in South Africa. These new markets in
commercial paper, corporate bonds and securitised
assets are bound to have a major impact on the
financial system in general and the banking industry
in particular (see Section 3.5 below). In future the
government bond market may shrink somewhat
owing to the proceeds from privatisation and greater
fiscal discipline, but private enterprises (including
banks) are expected to make increasing use of the
securities markets. The end result of this type of
enhanced competition from the securities markets
will be lower interest margins and reduced loan
business for banks. In fact, some of the
undercapitalised banks in South Africa may be
forced to look for assistance in the securitised asset
markets, inter alia as a means to fulfil their capital
adequacy requirements29.
The South African securities markets will probably
face a period of increased consolidation in the years
ahead. This consolidation process is an international
phenomenon and it is unlikely that South Africa can
distance itself from it. Consolidation in the securities
markets is driven by factors such as the following:
• Consolidation processes in the United States and
particularly in the European Union (with the euro
creating new financial markets) are bound to have
major side-effects in South Africa.
• Deregulation and freer trade are helping to
consolidate international firms into a handful of
international financial centres.
• Technology, particularly in clearing and
settlement systems, will support economies of
scale and thus the consolidation of various
exchange activities.
• The tendency of capital to look for low costs, high-
quality skills and lenient regulation, results in the
29
If a bank is undercapitalised and its shareholders are unwilling to
support it in a rights issue, one alternative for the bank would be
to securitise part of its assets (usually mortgage loans and
instalment credits) and so reduce the size of its asset book in line
with its available capital.
Financial Regulation in South Africa: Chapter 7
 consolidation of finance into a few financial
centres with international efficiency30.
• The international wave of mergers in finance is
shaking up entrenched businesses. These mergers
are, as a rule, across borders, as securities firms,
banks and fund managers build their global
businesses.
• To improve their risk-management systems,
particularly operational risks and thus human
resource management31, there is a strong pull
towards centralisation in a firm.
• The financial industry likes to cluster because clusters
create innovative – and therefore competitive –
businesses32.
There is little doubt that the securities markets in
South Africa will become even more international in
the years ahead. Similar to the banks that have already
established major treasury operations in their overseas
branches, the securities markets (exchanges) may start
to reallocate part (or even all) of their operations
abroad. Such a development would imply that all
securities traders in the local market could become
remote traders. An international trading platform for
the South African securities markets would have a
number of powerful advantages. These are for
example: the full integration of local operations with
the international capital markets; strongly capitalised
institutional traders; access to a large pool of highly
skilled labour and expertise; and a level playing field
between local and overseas brokers.
Liquidity, the Achilles heel of the securities markets,
will be further enhanced if the traditional exchanges
30
Around the world no self-respecting politician lacks plans to turn
his/her city into a capital of finance. For most cities this is simply
a pipe dream. Drawbacks in South Africa are, for instance, that
the country is not a net exporter of capital and is a long distance
from industrialised countries. Anyhow, the promotion of a
financial centre is not a regulatory task, but primarily a
responsibility of the central bank.
31
Major losses have occurred in the past because human
management was too dispersed (e.g. Barings, UBS, NatWest and
Daiwa).
32
Of course, a “rough neighbourhood” will chase the muses away.
And without the arts (particularly artful business lunches), the
skilled staff of the banking industry cannot be truly happy. A
financial centre simply cannot blossom on a “sports” culture.
Financial Regulation in South Africa: Chapter 7
could be broken down into three separate (but
seamlessly connected) operations: (i) execution; (ii)
clearing and risk management; and (iii) settlement and
delivery systems. In essence, an exchange proper only
trades in information. Accordingly the execution of
trades could be conducted in future on many different
platforms simultaneously. Execution specialists could
be the traditional exchanges (or various competing
exchanges), Internet exchanges, or any other form of
electronic community network (ECNs). The clearing
and risk-management operations of a market could
well, in future, be taken over by the large primary
dealers, such as J.P. Morgan, Merrill Lynch, Morgan
Stanley and ABN AMRO. These firms have first-class
trading names internationally, extensive capital
resources and expertise. The clearing-house for South
African securities could, in such a scenario, become
part of an international clearing system such as
Euroclear (which is operated by J.P. Morgan). In
future the execution of securities trades could well be
performed on various platforms, predominantly from
abroad. Clearing could be carried out domestically by
a large international specialist in this field. Traders
would have a choice of more than one of these clearing
systems33 as they would be compatible.
Because separately operating clearing and risk-
management systems can simultaneously deal
effectively with many different execution channels,
competition in trade as well as cross-market risk
management will improve. Such systems also allow for
better netting of trading positions, both in the spot and
derivative markets. Finally, the settlement and delivery
system (including a central depository) could be
operated as a separate local activity, although it could
be provided by the same institutions running the
clearing systems (as already happens with Euroclear).
If South African securities markets develop roughly
along the abovementioned lines, the local market could
well split into two tiers. The first tier would consist of
blue-chip multinationals that are likely to have their
33
In the international securities markets there is, for example, the
choice between Euroclear, Clearstream and Clearnet.
165
primary listings on the London Stock Exchange and
their secondary listings on the JSE. Their internal
governance and prudential standards would be world
class and accordingly have immediate access to the
international capital markets and no exchange controls.
The foreign home regulators would do the regulation of
these companies, while South Africa would become in
essence a host regulator. The South African National
Treasury could also be part of this first-tier market. It is
in the government’s interest to have a notable slice of
its bonds listed abroad (i.e. either as eurorand bonds or
international bonds). The reasons for an overseas
presence by the Treasury are the familiar ones, such as
enhancing liquidity standby facilities, securing capital
inflows or simply raising the government’s profile
abroad. Already commodities and currencies are
trading around the globe, so it is probably only a matter
of time before bonds and equities will do likewise. The
basic problem seems to be that global capitalism is not
matched by a “global society”.
The second tier in the securities market would
consist mainly of local companies, with local clients
and local personnel. The local authorities would be the
home regulator for this market segment. The standards
for this second-tier market may be close to but not
necessarily the same as those of the first tier, because
of some country specifics. As the top 25 companies on
the main board of the JSE account for some 80 per
cent of market turnover, the second-tier market will be
relatively small in turnover and therefore less
profitable for broking firms.
Today, the exchanges in the major financial centres
cross borders with ease. This in turn results in sharply
increased competition and remote trading. The
exchanges are under huge pressure to reduce costs and
to consolidate in strategic critical areas so that they
stay competitive. To facilitate this transformation,
exchanges are changing their ownership structures
from mutual to shareholder-owned organisations. An
exchange owned by shareholders, rather than its
trading members, has the advantage that it avoids
conflicts of interest, which in turn enhances quicker
and cleaner decision making. Once this change in
166
ownership structure is complete, the exchanges look
critically at their execution, clearing and settlement
structures. These fundamental functions in turn can be
consolidated or split off. For instance, clearing and
risk management can be consolidated with other
exchanges (e.g. embracing both spot and derivative
exchanges) or cross-border (e.g. consolidating local
and foreign clearing systems), and execution functions
can be placed on a highly competitive basis (e.g.
traditional broking vis-à-vis electronic broking
channels). To date, international experience indicates
that alliances between exchanges are more popular
than full-scale mergers. Although the ultimate aim of
the exchanges may be to create a “virtually integrated
market”, a “network of networks” seems, for the time
being, to be more probable than such a single
integrated network. In short, the immediate aim is a
large expansion of remote trading.
No doubt, from a regulatory perspective, the
securities markets will become a major focus point
in future, not only because of the expected dynamic
growth in this market segment, but primarily
because the new and changing aspects require the
regulatory framework to keep pace. In summary,
some of the issues that the regulators have to address
are the following:
• Commercial paper and corporate bond markets:
The development of these markets seems only a
matter of time, and South Africa clearly lags
behind international trends here. How are the
regulators to support these developments without
compromising consumer protection goals?
• Securitised asset markets: Seen from an
international perspective, like the commercial
paper market, this market is grossly
underdeveloped in South Africa. One of the
reasons might be that the underlying regulation is
still dominated too much by banking legislation.
• Clearing and settlement systems: Particularly
worrying here are the outdated settlement systems
of the JSE. Globalisation of the execution activities
in the equity market (either the JSE or a new
competitive exchange) are a possibility.
Financial Regulation in South Africa: Chapter 7
• Remote trading and foreign competition:
Electronic trading is bound to change the structure
of the local securities markets fundamentally. The
key issue for the regulators is the impact of remote
trading on systemic risk management. The
regulatory example for the authorities could be the
foreign-exchange markets, where the market itself
is free of regulation, but not its participants34.
• Competition from e-exchanges: Although it is still
early days, the regulators have to now consider
carefully the possible consequences of the
execution of trades through inter alia the Internet.
• Liquidity management and systemic support: As
the securities markets grow in size, their
importance in systemic risk management growths
proportionally. The authorities face here the
fundamental question of under what conditions
they are willing to support these markets during a
liquidity crunch.35
• Circuit breakers and super-regulation: The super-
regulation of markets becomes of crucial importance
if one market stops trading36 and other markets
continue trading in similar instruments or their
derivatives. Should the authorities impose circuit
breakers on exchanges? And, if so, should these
circuit breakers be applied automatically to other
exchanges as well (local and abroad) in times of a
liquidity crisis? The current trend is for exchanges to
move away from the use of circuit breakers.
• Cross-market risk management and netting:
Typically, the questions faced here by the regulators
are whether effective cross-market risk can be
managed properly if every exchange manages in
isolation only the risk exposures of its own members,
or whether trading positions in different exchanges
may be netted for prudential requirements.
34
In the foreign-exchange markets, brokers use one another’s
systems (e.g. Reuters), trade at the same price and exchange the
same legal contracts.
35
In fact, during crisis management, the authorities are always
confronted with the trade-off between the provision of liquidity
and the implied moral hazard.
36
For whatever reason: e.g. computer failure or a liquidity crisis.
Financial Regulation in South Africa: Chapter 7
• Supervisory structures: Currently the capital
adequacy of banks is supervised by the SA Reserve
Bank, whereas that of brokers by the exchanges
(predominately the JSE) themselves. The regulators
have to consider whether it is better, from both a
competitive and prudential viewpoint, to supervise
the prudential requirements of all securities firms
(i.e. exchange members as well as OTC firms)
centrally using systems similar to Euroclear.
How the authorities decide to deal with each of the
above issues will have a major impact on the
competitive position of the South African securities
markets during the next decade. Clearly, the securities
regulators face “interesting times”.
2.4.3 Financial infrastructure
In recent years, major progress has been made with
improving the infrastructure of the South African
financial system. However, it is unlikely that the speed
of change will slacken in the years to come. In order to
support the three pillars of the financial system (i.e.
institutions, markets and infrastructure), three sets of
incentive systems (i.e. internal governance,
supervision and market discipline) have to be
developed rapidly. These incentive systems have both
a private and a public-sector dimension.
Private-sector incentive arrangements
• Corporate governance rules: As a matter of
urgency South Africa’s corporate governance rules
have to be adjusted to best international standards.
• Accounting and audit rules: Generally accepted
accounting rules have to be made compulsory for
the financial reporting of any company in order to
enhance transparency. The Companies Act
requires an urgent amendment in this respect.
Likewise, audit rules have to be improved to
international best standards, particularly for global
financial conglomerates.
• Disclosure and transparency: Many adjustments
have been made in this area since the mid-
1990s, but there is still plenty of scope for
providing better information to the financial
press. An example would be far more useful
167
 information on competitive structures and
investors’ support profiles.
• Market monitoring and discipline: As the securities
markets become increasingly placed in a
competitive position, it becomes easier for the
market to monitor and discipline traders and
financial intermediaries. The authorities have to
support this market process wherever possible and
generally give the markets greater responsibilities.
• Private-sector ratings: The authorities, for
prudential requirements, have to recognise more
explicitly the ratings of private-sector agencies,
particularly their ratings of financial institutions
and securities market instruments.
• Capital-adequacy rules and value-at-risk systems:
Although the authorities stipulate an absolute
minimum capital standard based on risk-weighted
assets, they should encourage the use of in-house
value-at-risk systems in financial institutions, as
such systems explicitly take the inter-relationships
of portfolio compositions into consideration.
Public-sector incentive arrangements
• Supervision of complex groups: A draft Financial
Conglomerates Review Bill has been drawn up by
the FSB, but much work has still to be done on this
topic. This situation exists despite the fact that the
nation’s largest insurer (the Old Mutual Group)
already operates as a large global financial
conglomerate from the UK.
• Competitive neutrality vis-à-vis global financial
conglomerates: From an internationally
competitive perspective it is crucial that the
authorities ensure a level playing field by
reconsidering, for instance, their transaction taxes
on securities trade.
• Home and host regulatory arrangements: The
regulation of complex groups implies a far greater
degree of co-operation between home and host
regulators than is currently the case.
• Super-regulatory agency: Ideally the supervisory
structure follows the structure of the supervised
institution. Accordingly, complex groups have to
be supervised by a multidisciplinary agency or
168
arrangement (i.e. embracing both banking and
insurance specialists). Moreover, such a
supervisory team may consist of home and host
regulators. Research on this issue has only just
commenced in South Africa.
• Safety net arrangements: Deposit insurance, and its
link with the lender-of-last-resort facilities of the
central bank, is currently under investigation in
South Africa, and the implementation of new
policies may have a major impact in years to come.
• Financial stability policy: In 2000 a Financial
Stability Unit was established at the SA Reserve
Bank to address all questions of a systemic nature.
Much work has still to be done in this area.
• Co-operation between non-bank supervisors and
the central bank: As the public sector lacks the
discipline of the profit motive, it is far more
difficult to ensure co-operation than in the private
sector. A Memorandum of Understanding has been
drafted between the FSB and the Registrar of
Banks to ensure effectiveness and efficiency, but
more detailed work still needs to be done.
• Financial fraud and money-laundering control
systems: The government has still to decide
whether the SA Reserve Bank or the National
Treasury is going to undertake this regulatory
responsibility.
• Exchange controls: Considering that there are an
estimated R20 billion in blocked rands still
outstanding and a mismatched forward currency
book of some US$10 billion, exchange controls
cannot be lifted immediately in a Big Bang
fashion. Nonetheless, internationally competitive
forces make it essential to remove this constraint as
soon as possible.
• Regulatory accountability: In the end any sensible
accountability of the authorities can only be
ensured if a regulatory audit agency is established
by Parliament. Nothing has yet been done in this
respect in South Africa.
From the issues stated above it is clear that the South
African regulatory agencies confront a challenging
agenda for the next decade. Time is clearly not on their
Financial Regulation in South Africa: Chapter 7
side. In fact there is a distinct danger that a regulatory
failure may badly affect South Africa’s competitive
position in years to come.
3. Regulatory targets and gaps
The essence of regulatory targets is that they can be
quantified, i.e. targets can either be hit or missed. The
authorities should be able to state – i.e. after a
specified time period – whether they were successful
in the stipulation or establishment of, say, minimum
standards, or whether their support of or
encouragement for specific private-sector initiatives
did bear fruit. A regulatory gap37 is likewise
quantifiable, but of course avoided wherever possible.
This section summarises the various regulatory
targets that support the regulatory intermediate goals as
identified in Chapter 2. Most of these targets are
refinements of existing regulatory instruments, i.e. by
improving their regulatory instruments the authorities
hope to better target their intermediate goals (see
Chapter 4). The various intermediate goals are
addressed in the same order as they appear in Table 4.1
(see Chapter 4). Accordingly, Sections 3.1 to 3.6 below
aim at supporting the objective of systemic stability;
Sections 3.7 to 3.9 focus on institutional safety and
soundness objective, while Sections 3.10 to 3.15
support the objective of fairness and consumer
protection. The approach in this section is along the
following lines: to begin with, a short overview is given
of the issues at stake for each intermediate goal, and
thereafter the specific regulatory targets are identified38.
3.1 Competitive market infrastructure
The South African financial sector has a great
concentration of economic power. In terms of value
37
Often these gaps result from regulatory failure – either in
regulatory structure or plain mismanagement.
38
Once the major targets are identified, they could be grouped in a
number of similar classes and be handed over to specific task
groups for investigation and execution. The successful attainment
of targets could imply that these targets would be dropped from
the list of future targets. However, this is unlikely in practice, as
targets are hardly ever completely finished (e.g. fulfilling
minimum accounting standards is a moving target as these
standards themselves change over time).
Financial Regulation in South Africa: Chapter 7
added, the four largest banks represent some 75 per
cent of all the industry’s business, while the four
largest assurers have a 65 per cent market share.
Likewise, securities trading on the financial
exchanges is dominated by about five large (mainly
foreign) companies. Limited competition is one of the
reasons for this state of affairs. For instance, the
existing statutory limitation that foreign banks may
not accept from the general public deposits of less
than R1 million rand excludes them effectively from
the retail market, while the stipulation that foreign
insurers have to establish a local subsidiary (rather
than a branch) to write insurance has severely limited
foreign competition. Likewise, the dominant position
of foreign primary dealers in local securities trading is
primarily a direct result of South Africa’s dependence
on foreign capital inflows as well as too protective a
regulatory policy on undercapitalised stockbrokers for
too long39. In-house rules may also limit competition.
The members of the JSE for example cannot easily
start a competing local exchange as they are only
allowed to hold membership of BESA and SAFEX
within South Africa.
To ensure that the South African financial industry
can perform satisfactorily in the long term – i.e. under
the pressures of globalisation, liberalisation, financial
innovation and deregulation – the authorities have to
create a competitively neutral environment between
local and foreign financial services providers. The
authorities themselves cannot actively guide the
financial industry in the new world of, for instance,
e-money, e-commerce and electronic broking (whose
services are directly available through any computer
linked to the Internet). Technology continuously lowers
the barriers of entry and distance. Internationally
networked computers distribute information with great
speed that undermines traditional local operations.
These technological developments are bound to change
the competitive conditions fundamentally in South
Africa, and at best the authorities can assure that the
39
Clearly, the Big Bang on the JSE should have occurred far earlier
than 1995.
169
most efficient players in the local market win in this
game. As a “referee” the authorities should be
concerned with the “rules of the game”, rather than
whether a local or foreign player wins in this game.
The regulator should be concerned primarily with the
risk exposures of firms (e.g. sufficient capital and
management skills), irrespective of whether these
resources are financed by local or foreign investors. In
short, in an increasingly globalised industry, it is
neither effective nor cost-efficient to behave in a
protective nationalistic manner.
In order to increase competition in the local banking
industry, the South African authorities could conduct
an investigation similar to that of the Cruickshank
Commission in the UK, whose final report became
available in March 2000. This Commission found that
British banks: (i) were making monopolistic (cartel)
profits from the payments system; (ii) were too often
allowed to write their own rules in the name of
systemic soundness; (iii) were granting too few loans
to small businesses (because of local monopolistic
powers, but also because the entrepreneur lacked the
necessary risk capital to support the bank loan and the
government failed in its “loan guarantee” programme);
and (iv) were not supplying sufficient useful
information to consumers. Moreover, the Commission
recommended that a core banking account should be
made available to the public by the government, which
should call for tenders from the banks to provide that
service on behalf of the government. Considering that
the South African banking industry is more
concentrated than the British industry and less subject
to international competition, it would be beneficial if
these same issues were scrutinised in the local market.
To promote a competitive market infrastructure in
future, the South African authorities could focus on the
following regulatory targets:
• Establish a payments system open to all financial
institutions: The authorities should license access
to the payments system and remove unnecessary
entry barriers and any uncompetitive practices
between banks40. Obviously opening the payments
system should not result in more settlement risk,
170
and competition has to take place on a level
playing field (i.e. in terms of capital requirements,
settlement accounts with the central bank and cash
reserves). In addition, new entrants should share,
on a fair basis, the costs of the infrastructure that
supports the existing payments system.
• Promote competitive trading, clearing and
settlement systems: Without effective and efficient
operational systems, systemic risk management is
seriously impaired.
• Promote competitive listing requirements: Unless
local listing requirements meet minimum
international standards, local companies may find it
difficult to obtain international finance.
• Stipulate minimum infrastructural standards:
Corporate governance, accounting, audit,
transparency and disclosure rules are of particular
importance in addressing major operational risks.
• Establish interrelated and competitive markets:
Financial engineering enforces a close
interrelationship between new and different
markets, which in turn improves efficient pricing
and thus competitive market conditions.
• Establish regulatory neutrality towards foreign
participants: Only through foreign competition can
the authorities combat possible local cartel
structures in finance and ensure that the industry
remains globally efficient. Foreign competition
encourages domestic banking practices to approach
international best standards.
3.2 Acceptable maturity and currency
mismatches
Systemic risk management emphasises that the
maturity mismatches of loans and currencies should be
“acceptable” for both companies and the nation at
large. In financial firms their in-house value-at-risk
models ultimately check these maturity mismatches.
The greater the risk taken, the higher the resulting
40
This step is not simplistic and may have consequences for the
availability and distribution of money, the accommodation
policy, the lender-of-last-resort function and the SA Reserve
Bank’s regulatory responsibilities for the payment system.
Financial Regulation in South Africa: Chapter 7
capital adequacy requirements. However, the
government does not subject itself to such prudential
requirements, which creates serious problems at times
(e.g. Russia, 1998).
Once currency and maturity mismatches have built
up, particularly relative to long-term debt, they
become very difficult to resolve. The Asian crises in
the late 1990s emphasised this point. Asian banks were
financing their lending with short-term (often call)
deposits, and preferred rolling over their short-term
loans (permitting market liquidity and corporate
creditworthiness). As Asian corporates had no access
to long-term financing in the domestic markets, they
turned to the international markets with the resulting
currency-risk exposures. As this borrowing was done
on an uncovered basis, major currency risks soon built
up. A hardening in macroeconomic policy brought this
house of cards down eventually. The solution to this
type of dilemma lies in the development of a long-term
debt market in the local currency. By its nature this is
a time-consuming exercise.
South Africa withstood the Asian crisis relatively
well, mainly owing to the quality of its financial
regulation and supervision. Nonetheless, inherent
problems are easy to spot in the South African currency
book. To obtain long-term foreign capital during the
lengthy episode of political and financial isolation, the
South African government aggressively supported any
foreign borrowings of local companies by granting
forward cover at subsidised costs until the late 1980s41.
Owing to this long historical legacy of massive cross-
subsidisation, South Africa is today saddled with a
poorly structured currency book. Repositioning this
book will take many years, as the government will
have to buy foreign currency during periods of rand
strength and then use these proceeds to reduce the
forward oversold position of some US$10 billion.
Accordingly, the rand will remain an inherently weak
41
In the past, foreign borrowing has tended to be sporadic and ad
hoc, with confused roles between the private and public sectors.
Government should consider a regular programme of foreign
borrowing and the establishment of a reliable market for South
African paper in the international markets.
Financial Regulation in South Africa: Chapter 7
currency at least until the forward book is more
balanced, and ideally handed over to the private sector.
To promote a better-structured loan and currency
book in the years to come, the South African authorities
could focus on the following regulatory targets:
• Promote accurate value-at-risk systems: Without
VaR modelling techniques it is impossible for the
authorities to define “acceptable” mismatches.
• Promote the management of the forward currency
book by the private sector: On the basis of
principle, the government (i.e. in practice the
central bank) should not be responsible for the day-
to-day running of this exposure and it should be
handed over to the private sector as soon as
possible.
• Promote prudent debt-management systems in the
public sector: In order to promote an active bond
market and to avoid the build-up of systemic
pressures, the government should ensure that its
public debt is managed professionally42.
3.3 Acceptable cross-market exposures
Cross-market exposures are still poorly regulated in
South Africa. If trade on one exchange halts for
whatever reason, it is still unclear how other
exchanges would react to this. Co-operation among the
exchanges is difficult to enforce in view of their
underlying competitive nature. South Africa does not
apply circuit breakers on exchanges43 and accordingly
these mechanisms are not integrated into the overall
risk-management systems of markets. A fundamental
problem may be the existing structure of local
exchanges which do execution, clearing and settlement
on an integrated basis per exchange, rather than
breaking these functions up and integrating the
clearing and settlement functions across exchanges.
Today the spot and derivative markets have become
42
For example, one of the EU fiscal yardsticks is that the
government debt/GDP ratio should not exceed 60 per cent.
43
Whether such circuit breakers are desirable in the South African
context is a different question. Preliminary investigations, carried
out by Quant Financial Research, seem to indicate that such
structures are undesirable.
171
so intertwined, that the risk management thereof is
probably best performed by one entity rather than
having this function split among different exchanges.
To enhance competition between exchanges and to face
the expected competition from e-exchanges (which are
likely to be outside South Africa’s jurisdiction), it is
probably better that the local exchanges should start
concentrating solely on their execution functions. Such
a structure implies that the risk management, clearing
and settlement systems would be left to more
specialised and better capitalised institutions.
To support the intermediate goal of better cross-
market risk management, the following regulatory
targets can be identified:
• Establish cross-market risk management, clearing
and settlement facilities: Without such facilities
major risk exposures can fall into the cracks
between the various markets.
• Establish legally binding netting agreements
between markets: Risk management requires
offsetting positions in different markets to be fully
taken into consideration in the overall risk
assessment. Ideally all markets could use the same
legal contracts for netting purposes.
3.4 Sufficient market liquidity
Liquidity in the securities markets usually ebbs and
flows with the movements of the business cycle.
Liquidity-enhancing instruments are fundamental to
securities markets. For instance, one of the reasons that
futures contracts were developed alongside forward
contracts was their liquidity-enhancing qualities.
Likewise, dual-capacity trading is encouraged on
exchanges to support the liquidity-enhancing qualities
of well-capitalised market makers. The large
international investment banks usually perform the
function of market makers and they prefer to operate on
the large exchanges in the international centres. In any
case, large exchanges attract more liquidity than small
exchanges. The more liquid the market, the less the
“impact” cost of conducting large trades. Investors
avoid small exchanges as they have small trading
volumes and therefore prices may move against them
172
when they make big trades. This is the fundamental
reason for the monopolistic nature of exchanges:
trading always gravitates to whichever market has the
biggest share of liquidity in a specific security. And it is
inter alia for this fundamental reason that competition
among exchanges has to be promoted wherever
possible by the authorities, as only competition can
ensure the lowest costs to the consumer.
South African markets are competing with foreign
exchanges for liquidity. For locally traded securities
this competition can be faced without any great
difficulties, but for South Africa’s large multinational
companies this competition is fierce. As noted earlier,
fund managers (and particularly foreign fund
managers) go to the market with the least impact cost,
and if that market is found on the London Stock
Exchange, the JSE will fight a losing battle to
compete, at least for its most liquid internationally
quoted shares.
Beside impact cost arguments, a financial centre’s
attractiveness depends crucially on the tax regime.
Withholding taxes or transaction taxes imposed
unilaterally by the government can result in a massive
shift in funds, and can even cause the demise of a
financial centre.
The conditions under which the authorities are
expected to assist the securities markets during a
liquidity crunch have become, recently, a hot topic
among the monetary authorities. The tendency seems
to be towards less support by the authorities and more
reliance on the market mechanism to detect in good
time any drainage of market liquidity.44
To promote liquid markets as an intermediate goal,
the South African authorities could focus on the
following regulatory targets:
• Establish a financial stability unit at the central
bank:45 Such a unit should monitor liquidity
conditions particularly in the securities markets as
44
For instance during the crisis around Long Term Capital
Management in 1998, the US Federal Reserve arranged a private-
sector rescue package rather than easing its monetary policy stance.
45
At this time (August 2000) this unit is in the process of being
implemented.
Financial Regulation in South Africa: Chapter 7
 any crunch here quickly flows over to the banking
sector and the foreign-exchange markets.
• Formalise the standby facilities of the central
bank: The financial markets need, at times,
assistance from the monetary authorities, and the
basis of such assistance has to be published ex ante
in great detail46.
• Remove (tax) constraints on market turnover: To
maintain a level playing field internationally and
improve the attractiveness of local markets, the tax
authorities should think twice before imposing
transaction taxes and stamp duties on the securities
trade. Currently the JSE is subjected to a 0,25 per
cent transaction tax (i.e. the Marketable Securities
Tax), which, for instance, does not apply in the
UK. To avoid paying this indirect tax, foreign
investors would obviously prefer the London
market. Moreover, bankers’ acceptances, fixed-rate
deposits and promissory notes attract stamp duty of
0,05 per cent and listed instruments a duty of 0,25
per cent. These tax differentials between nations
and local markets create price distortions between
closely integrated markets and drain liquidity from
the local markets.
• Promote foreign participation in local markets:
Only the large foreign investment banks and fund
managers have the capital resources and the
expertise to support liquidity in the local markets
on a daily basis. With the increased globalisation
of finance, it is probably a better regulatory
strategy to take foreign competition kindly by the
arm, than to challenge it permanently on all fronts.
3.5 Securities markets as an alternative
to financial intermediation47
Securitisation – i.e. the process that turns loans into
tradable securities – has the major advantage that it
removes the need for borrowers to stay close to
46
See for instance: Bank Supervision Department, Annual Report,
Pretoria: The South African Reserve Bank, 1999, pp. 4–19.
47
Currently the external funds provided to non-financial businesses
in South Africa are comprised roughly as follows: 46% bank
loans, 32% equity, 18% bonds and 4% other sources.
Financial Regulation in South Africa: Chapter 7
lenders. In contrast to banks, bond lenders rely on
credit-rating agencies to rate the securities in terms of
the borrowers’ creditworthiness. Usually the lenders’
exposure to one specific private borrower in the
securities markets is small, as their assets are spread
much wider than bank loans. Moreover, lenders in the
securitised asset markets have tradable paper that
makes their ability to adjust their risks easier, which in
turn lowers the cost of borrowing. Current legislation
in South Africa in respect of securitisation is still
influenced by banking legislation, but over time these
constraints are likely to be lifted. Once this occurs the
securities markets will rapidly grow and become a
major competitor to the banking industry.
Although access to credit can always be improved,
generally banks have advanced extensive credit to
small, medium and micro-enterprises (SMMEs),
provided these enterprises were adequately capitalised
and had the necessary managerial skills. The basic
problems in South Africa’s microlending industry are
the inadequate capitalisation of these businesses and
the high risks attached to the granting of this type of
venture capital. The demand for credit is aggravated
by the fact that unemployment is running at
excessively high levels and that the credit institutions
were unable to provide risk capital at the bottom end
of this market on a sustainable basis. In essence, these
loans cannot be made part of the normal commercial
and prudential activities of the banks.
Perhaps in the years ahead, more venture capital,
even for small and micro-enterprises, could be
funded – at least partially – through the securities
markets. When it comes to the granting of credit the
securities markets can compete effectively with
banks, and they may be even more cost-efficient in
this higher risk area. Anyway, the supply of credit is
not exclusive to banking. Many institutions (both
financial and non-financial) grant credit. The needed
investment funds for SMMEs (or housing finance for
that matter) can in principle be generated through the
securities markets on a competitive basis vis-à-vis
the banks. The advantages of this type of funding are
the following:
173
• In contrast to banks, securities markets cannot
become insolvent but only illiquid. As a result they
are able to accept more market risk than banks.
Historically the financing of risky business always
took place primarily in the capital markets (i.e.
equities or bonds)48.
• Direct financing through securities markets
implies a direct knowledge link between ultimate
lenders and SMME funds. Accordingly investors
can have a direct say in how their investments are
to be utilised.
• The rating of SMME funds, i.e. in terms of the
quality of their paper, can be done by private rating
agencies and the investing public can select funds
according to their desired risk profile.
• By stipulating that SMME bonds should be
traded on a regulated investment exchange (e.g.
the BESA), standard investor safety features can
be secured.
• By making SMME bonds negotiable, investors
can obtain a relatively liquid investment
instrument that directly reflects the markets’
sentiment and in turn disciplines the lending
operations of SMME funds.
• Foreign development agencies, trade unions, local
communities, etc. may be more inclined to invest
directly in socially acceptable projects.
• By increasing the competition between banks and
securities markets, prices for debt are likely to
reflect better relative scarcity.
• From the viewpoint of systemic stability the
strength of the financial system is improved if the
securities markets are comparable in size to
financial institutions.
However, there are a number of disadvantages to
this approach. Financing SMMEs partially through the
securities markets will have the natural setbacks of any
instrument traded in these markets, such as:
• The market for SMME bonds may lack sufficient
48
Indeed, wars can be financed by selling war bonds, but not by
demanding war deposits! The upliftment of the poor in South
Africa is no less a battle than a major war, in terms of effort and
dedication.
174
liquidity because the investing public shows too
little interest.
• The yield on SMME bonds may fluctuate too
sharply during periods of financial instability.
• Financing through the securities markets requires a
higher degree of financial sophistication on the part
of investors than a plain bank deposit.
• Particularly if the investing public is uneducated,
disclosure rules and a critical financial press are of
crucial importance.
However, all these disadvantages are not of a
principle nature and the authorities can address them
by promoting the securities markets in general.
Accordingly, to support the intermediate goal of
promoting the securities markets as an alternative to
financial intermediation, the following regulatory
targets can be identified:
• Remove constraints on commercial paper and
corporate bond issues from the Banks Act: The
authorities can only consider this step after pending
legislation to improve consumer protection has
been passed by Parliament.
• Promote the engineering and implementation of
an SMME bond instrument: This instrument
should be designed and developed by the private
sector, but its initiation, development and the
establishment of a market need to be supported
actively by the authorities.
3.6 Regulatory effectiveness, efficiency
and economy
The UK is an example of a country where the
quality of regulation is one of the major strengths of
its financial system. For instance, wholesale
business in the UK is leniently regulated to ensure
international competitiveness, but retail business is
tightly controlled in order to protect the British
consumer. By contrast, the Securities and Exchange
Commission (SEC) in the US does not differentiate
as efficiently and effectively as the UK between
wholesale and retail business, which in turn so
easily results in the over-regulation of wholesale
markets. In fact, the undifferentiated regime in the
Financial Regulation in South Africa: Chapter 7
US is one of the reasons that their major investment
banks49 operate largely from the UK.
As trading in foreign markets becomes increasingly
indistinguishable from domestic trading, the
competition between regulatory agencies heats up
correspondingly. Although South Africa is still
somewhat isolated in this respect, it is unlikely to stay
in this position for much longer because its top
companies are rapidly diversifying abroad. Some of
South Africa’s blue chip companies have already
obtained primary listings in the UK recently, and the
JSE struggles to remain competitive with the London
market in terms of its ability to raise financial and
human capital more cheaply. Exchange controls and
the location of corporate head offices in “rough
neighbourhoods” are other hinderances for South
African companies with major foreign operations.
During the period 1998–2000 the JSE lost about a
third of its primary listing market capitalisation (i.e. if
companies with secondary listings are excluded from
the JSE market capitalisation). Although the JSE is
obviously not pleased to see its best equity counters
listed on competitive exchanges, there is ultimately
not that much that the JSE, or the government, can do
about it. Indeed, any South African company with
major interests abroad could split off its foreign
operations in a separate company abroad, if
permission to list abroad were to be withheld by the
National Treasury.
To avoid competition in regulatory laxity (i.e. the
“dive to the bottom” in regulation), two different
approaches have been developed in the European
Union. The first device is “harmonisation” in terms of
which national regulators adhere to certain minimum
standards, and the second device is the “mutual
recognition” of one another’s regulatory regimes (and
their differences). This mutual recognition results, in
turn, in concepts such as the “single passport”, “home”
49
The large US investment banks, e.g. Merrill Lynch, Goldman
Sachs and P.J. Morgan, already operate as truly international
companies, rather than US firms. Positioning their head offices in
London rather than New York would not be a big issue of
principle (except for tax reasons).
Financial Regulation in South Africa: Chapter 7
and “host” regulators, and “remote trading” regimes.
The single passport implies that any financial
institution can deliver its services throughout the EU
without incurring regulation from different
jurisdictions. The home regulator keeps an eye on the
soundness of, say, a bank, while the host regulator is
concerned with the bank’s business practices. Host
regulators must recognise the competence of home
regulators in the EU. Remote trading is an extension of
the home versus host regulatory regime. Again the
home country regulates the remote trader, while the
host country must allow remote electronic foreign
participation on its exchanges.
Outside the EU the host country can of course
refuse to recognise the home country as the
prudential regulator, but this becomes difficult if the
home country is the US, France, Germany or the
UK which have sound financial systems 50.
Accordingly, internationally, the tendency is
increasingly to deregulate the exchanges in full (and
thus to regulate them more or less like the OTC
markets) and instead to concentrate more on
institutions such as banks, securities firms and fund
managers. The argument is that with the
development of professional fund management
firms, the need to protect the retail client on the
stock exchange has largely fallen away. Nonetheless
the inherent danger of such a development is that
the equity markets may split into a first tier of blue
chip companies and a second tier of low-capitalised
companies. These smaller companies would struggle
more to generate capital on such “formalised OTC”
stock markets.
To support the intermediate goal of regulatory
effectiveness, efficiency and economy the following
regulatory targets can be identified:
• Establish co-ordination agreements among
50
One way to deal with the issue of the quality of the home
regulator is to subject the national regulators and supervisors to
a rating procedure. For instance, host regulators could be asked
to compile a checklist on how they determine the competence
of home supervisors. The BIS has already formally declined to
be involved in such a rating process, but the IMF may still
decide to do so.
175
 domestic regulatory agencies: unless such
agreements are in place, the authorities may be
confronted with regulatory gaps in the supervision
of complex financial groups.
• Establish harmonisation agreements between home
and host regulators: without harmonisation in this
area it would be difficult to effectively supervise
global financial conglomerates and hedge funds in
offshore financial centres.
• Stipulate regulatory cost-benefit analysis: the
danger of over-regulation can only effectively be
addressed if the authorities do detailed cost-benefit
analyses.
• Establish a regulatory audit agency: such an
agency would go a long way towards ensuring that
appropriate accountability takes place on the part
of the regulators. In most countries, parliamentary
scrutiny and accountability require more attention:
i.e. the select parliamentary committees have not
reached their full potential yet.
• Establish ratings of national regulatory agencies:
international bodies, like the IMF or the World
Bank, could perform this task.
3.7 Proper risk assessment
The major risk components of a financial firm are
market risk, credit risk, liquidity risk, counterparty
risk and operational risk. The aim of the new
capital-adequacy regime of the Basel Committee is
to back all these risks with sufficient capital by
2001. The original Basel capital accord of 1988
mainly addressed counterparty risk, and was aimed
primarily at: stopping the sharp fall in the capital
adequacy of internationally active banks; reducing
the competitive inequalities among countries; and
establishing minimum standards (though this
minimum soon became a universal standard). In
1995 the capital agreement was extended to include
market risk. The proposed new capital accord tries
to addresses all the other risk exposures of banks in
greater detail.
To evaluate credit risk, two approaches are proposed
by the Basel Committee: a standardised approach that
176
is reliant on external ratings51 or an internal ratings
approach for qualifying banks.52 Obviously the
industry believes that internal ratings offer the right
way forward (as bankers think they know their own
business better than agencies). Banks hope that
portfolio credit-risk models, which promise a more
accurate estimation of credit risk than the standardised
approach, will soon be acceptable for regulatory
capital purposes. There are however two major hurdles
to be overcome: data limitations and the lack of
credible back testing. Over the medium term these
issues will, no doubt, be addressed as better default
and loss data are accumulated.
A more serious problem over the long term is the
absolute level of capital required for banks. Rewarding
good risk management and a more differentiated
calibration of credit risks are likely to result in an
absolute decrease in the overall level of regulatory
capital in the banking system. The Basel Committee
thinks that this is undesirable, it would rather see the
capital standard raised to 10 or even 12 per cent of
risk-weighted assets.53 Regulators want to factor in
something – in their minds if not in their models – for
the unexpected. The justification for an arbitrary
minimum capital requirement emanates directly from
this need to cover the unexpected. Accordingly, they
propose an explicit charge for other banking risks that
at the moment are taken into account only implicitly,
particularly interest rate risk arising from the banking
51
By credit rating agencies such as Standard & Poor’s or Moody’s.
52
However, both these methods rely on the opinions of parties who
may have an incentive to underestimate that risk exposure. By
contrast, the advantage of the prescription of subordinated debt
as a form of regulatory bank capital would be that these opinions
are replaced by market forces and thus a reliance on private
agents’ behaviour. The potential use of subordinated debt is to
bring market forces to bear on the operations of large financial
institutions and to protect the deposit-insurance funds. See
Evanoff, D.D. and L.D. Wall, “Subordinated debt as bank
capital: a proposal for regulatory reform”, in Economic
Perspectives, Federal Reserve Bank of Chicago, second quarter
2000, pp. 40–53.
53
The current minimum capital requirement for large
internationally active banks of 8 per cent of risk-weighted assets
may be too low for South African retail banks, which are
relatively small and operate primarily in a developing country
environment.
Financial Regulation in South Africa: Chapter 7
book, and operational risk such as computer-related or
legal risk. However, the industry has many concerns
about such “add-ons”. Moreover, it is still not clear
how the internal rating approach could be made
comparable across countries that have different
banking legacies as well as different bankruptcy and
accounting regimes. To ensure that the new capital
regime does not give a competitive edge to non-banks,
the Joint Forum54 has to investigate the impact thereof
on the banks’ counterparts in the securities and
insurance businesses.
Sound risk-management systems require close co-
operation between the regulator and the regulated.
Ideally the regulatory framework should be as simple as
possible, though managements’ own control
superstructure can be as complex as they wish to make it,
subject to its being open to supervisory scrutiny. Good
management and good regulators seldom have reason to
fall out. The latest discussions on credit risk models
between the Basel Committee and the industry are
progressing satisfactorily in this philosophical context.
Proper risk management for systemic purposes does
not stop with financial institutions though. Also of
importance are the risk exposures of hedge funds.
After the US Federal Reserve had to launch a large-
scale rescue operation for the largest hedge fund in the
world, Long Term Capital Management, the risk-
management procedures of hedge funds and their
impact on financial stability came under the regulatory
spotlight in 1998. Hedge funds are by their very nature
highly geared, non-financial offshore institutions. This
makes them very difficult to regulate directly. In 2000
the Financial Stability Forum at the BIS recommended
that hedge funds should not be placed under direct
regulatory supervision, but that more disclosure should
be demanded from both them and their bankers (who
54
The Joint Forum (formerly known as the Joint Forum on
Financial Conglomerates) was established in early 1996 by the
Basel Committee on Banking Supervision (Basel Committee),
the International Organization of Securities Commissions
(IOSCO) and the International Association of Insurance
Supervisors (IAIS), to take forward the work of a predecessor
group, the Tripartite Group, in examining supervisory issues
relating to financial conglomerates.
Financial Regulation in South Africa: Chapter 7
usually grant the credit to them and thus largely allow
their high degree of gearing). As a result, many
bankers have compelled their hedge fund clients to use
value-at-risk models, which in turn resulted in a
massive de-gearing of those funds. As market liquidity
started to fall in line with less credit being made
available, the largest of the hedge funds, after showing
significant trading losses in 1999, withdrew from the
market in 2000. In quick succession some of the larger
funds, such as Tiger Fund, Quantum Fund and Quota
Fund, closed for business. The danger of such a
development is that it may cause a vicious circle: as
banks provide less liquidity, markets become more
volatile, forcing them to make further cuts in the
amount of capital they devote to trading, making
markets even less liquid, and so on. In the end, the
hedging of open positions is becoming increasingly
difficult. Although the South African regulatory
authorities are not really engaged with hedge funds
(exchange controls prohibit this type of bank lending),
the recommendations of the Financial Stability Forum
are to be implemented nonetheless.
To support the intermediate goal of proper risk
management, the following regulatory targets can
be identified:
• Promote accurate value-at-risk models: Ideally,
all risk exposures within a firm have to be
quantified on a fully integrated basis. The
building of such enterprise-wide risk management
(ERM) simulation models needs to be supported
by the authorities.
• Stipulate consolidated supervision: Without proper
accounting consolidation, the double counting of
regulatory capital is bound to take place.
• Appoint specific non-executive board members to
supervise risk management and management
control systems: Ultimately the authorities would
like to make one specific director at board level
responsible (and perhaps even accountable in a
private capacity55) for the firm’s risk-management
procedures.
55
This policy is currently enforced in New Zealand.
177
• Appoint accredited private rating agencies:
Paper traded in the securities markets has to be
rated for risk-management purposes. This task
can be left to the private sector but the ratings
need to be recognised by the authorities for
regulatory purposes.
• Promote unsecured subordinated debt as a rating
tool: Bank risk-management is structurally improved
if the interests of subordinated debt creditors are
closely aligned with those of the bank supervisors.
3.8 Proper financial institutional
infrastructure and suitability standards
A proper financial infrastructure is one of three major
structural pillars of a stable financial system56. From a
regulatory point of view, improvements in the
financial infrastructure usually go hand in hand with
raising the minimum standards. These standards, in
turn, entail accounting, audit, capital, governance and
compliance standards. As the process of international
standard-setting is one based on mutual agreement, it
can only be on the basis of consensus. Such a common
approach is based on a “bottom-up”, rather than a
“top-down” approach, which by its nature will be an
evolutionary process. In recent years major progress
has been made: e.g. international accounting standards
were endorsed by IOSCO in 2000, the OECD is
currently considering more uniform governance rules
for industrial countries, while the BIS is working on a
new capital accord.
In the South African context, segments of financial
infrastructure, need urgent attention. For example:
the transparency of the OTC markets (particularly
off-market trade) and nominee companies; internal
governance in relation to pyramid companies and non-
voting shares; and capacity for investigating
commercial crime and prosecuting offenders effectively
in the justice system.
To support the intermediate goal of a proper
financial infrastructure, the following regulatory
targets can be identified:
56
The other pillars are sound financial institutions and liquid markets.
178
• Adhere to minimum accounting and audit
standards: There cannot be proper disclosure
without proper accounting and audit standards.
• Adhere to minimum capital standards: Competition
in regulatory laxity emerges if no international
minimum standards are set in this area.
• Adhere to corporate governance standards: These
standards promote high-quality leadership in firms.
• Adhere to compliance standards: With increased
reliance on market discipline and monitoring, the
compliance function within firms becomes crucial
in ensuring proper in-house supervision.
• Establish an infrastructure for the verification of a
firms’ risk and control systems: Verification, as a
type of auditing process, has to ensure that the
simulation models and control systems used, will
live up to expectations.
• Establish an industry register of doubtful and bad
debts: To improve credit risk-management
procedures, the creation of a credit register – where
bank loans are classified in terms of size and rated
by independent rating agencies on an industry-wide
basis – is recommended.
• Stipulate suitability standards for directors and
senior management: Unless top management is
knowledgeable, battle-hardened and generally “fit
and proper” no company can face the global
competitive forces head-on in today’s financial
world for long.
3.9 Global institutional competitiveness
and competitive neutrality
A basic problem faced by all global firms is that their
activities are constrained by national regulation. In the
absence of a global government, how are regulators to
create a system of mutually interdependent and reliant
supervisors in which companies can compete on a
level playing field? Too much self-regulation may
result in regulatory laxity or regulatory capture, while
too much official regulation from the top may stifle
competition. In the end the relationship between the
supervised and the supervisor is symbiotic, and so it is
vital to encourage industry leaders to help develop the
Financial Regulation in South Africa: Chapter 7
appropriate standards, including codes of conduct and
prudential standards.
On the competitive front the Internet, hand in hand
with digital cash, is bound to have a strong influence
in future. From a regulatory perspective the Internet is
often seen as just another form of media. Although, in
a narrow sense, this is logically correct, the Internet
nonetheless undermines current regulation and
practices. One reason is that electronic documents are
different from their paper equivalents57. More
fundamental are the problems of jurisdiction (e.g.
investment advice given in London may be read in
Johannesburg, which in turn impacts on local
legislation covering investment advice) and home
country supervision (will foreign investors using a
website in, say, the United States have recourse to US
law for redress?). Financial scams are another potential
problem on the Internet. Because information on the
Internet is cheap to distribute and therefore reaches a
vast number of people, even a small response makes it
an ideal medium for “get-rich-quick” schemes (e.g.
pyramid selling). Ultimately consumers can directly
control their regulatory environment simply by “voting
with their feet” for the jurisdiction they like. Without
geographic barriers, consumers can elect the type of
protection they need by choosing their preferred
Internet regulator. This implies that unpopular
regulation, even with good intentions, will be difficult,
if not impossible to enforce in the long run. It seems,
accordingly, that the regulator of the Internet will be
no more than the well-informed consumer.
The regulatory response to all these Internet
challenges still needs to be worked out by
international task groups. It will be a daunting task,
particularly considering that national sovereignty, and
thus pride, is at stake. Therefore no quick answers
can be expected. Even as a minimum involvement,
South African regulators will have to follow these
international developments closely.
Most of the basic issues underlying global
57
For instance, typical problems are that Web pages change too
quickly; are easy to browse, but difficult to read; while “small
print” can be skipped too easily through the use of hypertext links.
Financial Regulation in South Africa: Chapter 7
competition have already been discussed in one way or
another above. Generally, South African companies
are globally competitive, but it is worth repeating that
exchange control regulations are still a major
hindrance as capital mobility has increased so much in
the last two decades. Therefore, to support the
intermediate goal of global competitiveness and
competitive neutrality, the following regulatory targets
are of particular importance:
• Abolish foreign exchange controls as soon as
possible: The free flow of capital underlies
competitive forces in the global economy.
• Adhere to international agreements on regulatory
minimum standards: These standards aim at
avoiding competition in regulatory laxity.
• Encourage a functional approach to regulation:
With the emergence of global financial
conglomerates it is of crucial importance that
functional regulation across various financial
sectors should be properly co-ordinated with
traditional institutional regulation.
• Encourage competitive neutrality between
commerce and e-commerce: The Internet may well
prove to be the vehicle that makes the “caveat
emptor” approach in regulation more sustainable.
3.10 Integrity, fairness and competence
Within the firm the compliance office deals with the
day-to-day issues of suitability. In the end it is the
compliance officer’s responsibility to ensure that only
people with integrity are appointed (called the “gate-
keeper’s” function), that the clients are dealt with
fairly and that staff is competent to do the work.
However, who guards the guards? To date, no
mechanisms for systematically assessing compliance
procedures have been developed58.
To support the intermediate goal of integrity,
fairness and competence the following regulatory
targets can be identified:
58
At the national level the IMF and the World Bank have put
together compliance assessment teams to conduct financial
assessment programmes. The national supervisors may have to
do the same at the corporate level.
179
• Encourage a code of corporate governance: The
major responsibilities in this area rest with the
board of directors.
• Encourage a code of business conduct: Industry
associations usually compile this code. It is already
in place in South Africa for the local banking,
insurance and unit trust industries.
• Establish a policy to reduce financial crime and
money laundering: Without such a policy South
Africa could become an undesirable business place.
Cabinet approval of the Financial Intelligence
Centre Bill, which deals with money laundering
control, is being awaited.
• Encourage effective compliance manuals: These
manuals can be seen as an incentive contract
between the regulator and the regulated and may
accordingly differ among financial firms. The
quality of the compliance manuals may have to be
certified by the external auditors of the firm in
consultation with the regulator.
• Stipulate “fit and proper” standards for the
compliance office: The external auditors and
regulators have to audit the quality of the
compliance office to ensure these guardians fulfil
standards themselves.
3.11 Adequate product and service
competitiveness
Protective feelings on the part of the authorities often
mean that they want to protect both their home turf and
their colleagues in the public sector. The result is trade
restrictions of various kinds against foreigners and the
exclusion of standard regulations for the public sector.
Both policies can prove extremely expensive in the
long term.
Public involvement in the financial sector can create
socio-economic benefits. For instance, a government
bank, like the Postbank, can provide effective
competition at the cutting edge in a market dominated by
private banks. Likewise, the Land Bank can assist where
the private sector may hesitate, because of its longer-
term commitment to agricultural development. However,
it would for a number of reasons be bad policy to
180
exclude such enterprises from the standard prudential
requirements (like capital adequacy or disclosure) or
even from the industry’s code of conduct requirements
(including the code of corporate governance policies).
Firstly, even if the government stands behind its
enterprises through thick and thin, the political election
cycle is far shorter than the average life cycle of a public
enterprise. A newly elected government may not want to
inherit over-stretched public sector budgets for political
aims they did not subscribe to, or face the legal
consequences of the bad financial advice given by public
servants. Secondly, efficiencies in the public enterprises
can only be measured between competing entities on a
level playing field. For example, the fact that the Land
Bank has a zero-cost capital base, is untaxed and has a
preferential creditor status to compete in the commercial
markets, results in serious market distortions. Thirdly,
without prudential requirements the taxpayer may once
again be asked to bail out, whereas winding-down would
have been the logical policy. Lastly, the financial
regulator should be careful when dealing with general
government, as historical evidence shows time and again
that state failure is far more expensive and painful to
society than market failure (see Chapter 4, Section 3.7).
To support the intermediate goal of product
competitiveness, the following regulatory targets can
be identified:
• Remove constraints on competitive foreign
products: True competition usually only flows from
different countries, different cultures, different
languages and different regulatory regimes.
• Remove regulatory exclusions granted to
parastatals or public corporations: Only by placing
the enterprises of the state on a equal footing with
private-sector equivalents can inefficiencies and
unacceptable risk exposures be detected.
3.12 Transparency and disclosure
Disclosure and profitability do not necessarily always
sit comfortably together. For instance, a company may
obtain valuable marketing benefits by giving the
impression of being ethically involved in “socially
responsible investments” (SRI), while in reality its
Financial Regulation in South Africa: Chapter 7
expenses in this area are primarily for advertising.
Ultimately, all predation is based on the fine
differentiation between the apparent and the real, and
the hunt for profit is no exception. In the end, investors
want to know how much of their funds is used for SRI
corporate goals. In order to make this type of
information more transparent, specific disclosure rules
should be considered. For instance, in July 2000, the
British made it compulsory for pension funds to
disclose whether they take account of the
environmental, ethical and social impact of their
investments. The aim of this regulation is not so much
to interfere in the investment patterns of pension
funds, but rather to ensure proper information flows to
investors and policy holders.
It is crucial for the authorities and industry
associations to make information, which is sufficiently
benchmarked, available to the press. Ultimately the
link between financial markets and consumers is the
financial press. The press plays a critical role in any
financial system and has to be educated and supplied
with relevant and updated information about market
conditions, investment patterns and the relative
importance of the various classes of investors and
borrowers. Questions like “who is really supporting
small businesses?” and “how much of the funds are
employed for SRI projects?” are not only of interest to
pressure groups and politicians, but also to market
participants in a broader sense. Disclosure is a
powerful instrument, provided it used properly – i.e.
no information overflow. The disclosure of selected
benchmarked information is the key to success.
To support the intermediate goal of transparency and
disclosure, the following regulatory targets can be
identified:
• Adhere to an international code of corporate
governance: Disclosure and transparency are in
essence components of internal governance.
Although every nation may have different ideas
about what appropriate disclosure means, it is
helpful for international investors if at least the
minimum standards are met in this respect.
• Establish government-defined benchmarks for
Financial Regulation in South Africa: Chapter 7
better consumer information: Often consumers find
it difficult to compare prices because of a lack of
standardisation. Officially agreed benchmarks,
including the cost of a “basic bank account”, will
better address consumer grievances. The regulatory
authorities, including the industry associations, can
do more to enhance the supply of competitive
information, inter alia via the Internet.
• Inform the financial press. The regulatory
authorities should establish a practical, mutually
effective, working relationship with senior
financial journalists in order to promote better
communication with the public at large.
3.13 Adequate access to retail
financial services
As emphasised by the Cruikshank Commission in the
UK, the uncompetitive behaviour of banks is often a
result of too-high capital charges for new entrants as
well as the banks’ cartel position in the payments
system. Likewise, for example, the practice where
banks charge non-clients significantly more for the use
of cash machines is perceived as a lack of
competitiveness. To lower entry barriers, the
authorities could consider establishing different types
of banks, and participation in the payments system
should be opened, in principle, to any financial
institution materially involved in payments.
In the past, specific licences were granted in South
Africa to different classes of banks such as
commercial banks, savings banks, general banks and
building societies (which were effectively mortgage
banks). Over the years all these distinctions were
eliminated because the functional borderlines
between these institutions became increasingly
blurred. In terms of the 1990 Banks Act only one
definition for a bank remained.59 However, to assist
the “unbanked” the authorities could define a “core
59
The Mutual Banks Act (1993) is similar to the Banks Act (1990)
except on two points: (i) a mutual bank is of course exempted
from the requirement that a bank has to be a limited company;
and (ii) its minimum capital is R50 million, but for a bank it is
proposed that it should be increased to R250 million.
181
bank”, being a bank that accepts deposits from the
general public and invests all its assets in money-
market paper of top quality (i.e. a core bank has no
credit risk). Core banks would have a lower capital
requirement than other, more universal banks because
their risk profile would be fundamentally lower. In
essence, a core bank’s deposit rates would be
determined by money-market rates minus operating
expenses. Retailers that currently provide limited
banking services could then be granted a full core-
banking licence and direct membership of the
national payments system (rather than as a bank’s
agent), which in turn would be bound simultaneously
to increase financial services to the poor and improve
competition in the banking sector.
A basic problem in the South African context
remains the conflicts of interest faced by the
authorities in ensuring prudential regulation and
compliance with international standards, and the
interests of Parliament in providing banking services
to the entire population. The danger of maintaining
international standards in a developing country is that
local banks participating in the international markets
may find that the costs of capital demanded by those
standards are just too high for the returns that can be
earned in the low-income markets. So the local banks
tend to contract out of the very markets that Parliament
would like to see them expanding into.
To support the intermediate goal of adequate access
to retail financial services, the following regulatory
targets can be identified:
• Establish core banks in the retail trading sector: A
one-size-fits-all banking structure is unlikely to be
satisfactory to both wealthy and poor retail clients.
• Open the payments system to non-bank financial
institutions: Core banks can only really compete
with established banks if there is a level playing
field in the inter-bank market and in the national
payment system60.
60
Subject of course to the earlier observations of level playing
fields, settlement risk and contribution to the costs of the existing
infrastructure.
182
3.14 Protection of retail funds
The issue of protecting retail funds is closely related
to the issue of financial soundness and financial
stability in general (as discussed in Chapter 5,
Section 3.5.2). In essence it implies that the
authorities ensure proper risk-management systems
in firms (e.g. in respect of operational risks) and
maintain macroeconomic stability. In this context the
emphasis is increasingly being placed on the market
monitoring and discipline61.
Generally, investments made by the public at large
are poorly protected in South Africa. If an investment
fund should go under as a result of, for instance, gross
negligence, usually no compensation is paid to the
investors.62 In respect of bank deposits, the authorities
are currently investigating the possibility of an
investor protection scheme that will pay limited
compensation to depositors.
Besides the Reserve Bank’s investigation into
bank-deposit insurance, the FSB is currently
investigating whether other retail investment funds
should receive similar protection. No doubt this is a
challenging investigation, as the current situation can
be roughly summarised as follows: to date no official
protection against operational or default risks is
given by the private sector (whether they are banks,
insurance, pension or unit trust funds), and most of
the public contributions to the public sector’s funds
have long since disappeared. For instance, the
Department of Labour is responsible for the
Unemployment Insurance Fund and the Workmen’s
Compensation Fund. Both these funds are effectively
bankrupt. The Department of Transport is
responsible for the Road Accident Fund. The
actuarial shortfall of this fund runs into billions of
rands. The Department of Health is responsible for
61
One of the regulatory reforms that powerfully support market
discipline is a greater role for subordinated debt as a form of
bank capital.
62
The official excuse is usually along the lines of “let the buyer
beware”, despite the fact that investors often lack even the most
basic information. Moreover some of these investments are made
compulsory like the Road Accident Fund or the Unemployment
Insurance Fund.
Financial Regulation in South Africa: Chapter 7
medical aid schemes63. The majority of these
schemes are in dire straits, although a few of them are
still actuarially sound. Considering the possibly huge
medical costs of Aids, TB and malaria, medical aid
schemes are probably one of the most risky forms of
insurance at present. The only exception in the public
sector seems to be the SA Special Risk Insurance
Association (SASRIA) managed by the National
Treasury that accumulated a massive surplus of some
R8 billion, more or less by mistake.64
The dilemma faced by government is that most of
these investment funds are used as instruments of
social engineering, though in a truly free market any
cross-subsidising between fund members is
impossible. Furthermore, prudential considerations
require that “the wishbone should never replace the
backbone”. Accordingly, these public sector funds
have to be appropriately financed for the benefit of
their paying members.
To promote better protection of retail funds in
future, the South African authorities could focus on the
following regulatory targets:
• Establish a Structured Early Intervention and
Resolution regime: Without timely and adequate
provisions, firms may fail in appropriate credit-risk
management.
• Stipulate acceptable operational risk-management
systems: Major computer system failure and/or
fraud are an important reason for bankruptcy in the
financial industry.
• Limit the use of retail investment funds as an
instrument of social engineering: Even with the
best social intentions, the investment funds will
face ruin in South Africa unless payouts are based
on actuarial principles.
63
This regulatory arrangement came about in 1975 when the
supervision of medical aid schemes was transferred from the, then,
Department of Finance to the Department of Health. Considering
the current financial problems of medical aid schemes and the
dynamic interaction with medical insurance in general, it seems
that this arrangement has probably passed its due date.
64
As the Government was the sole underwriter of the SASRIA
scheme, it took the lion’s share of the surplus from this fund by
means of the Conversion of SASRIA Act, 1998.
Financial Regulation in South Africa: Chapter 7
3.15 Retail compensation schemes
Compensation to a wronged investor should not be
viewed as a type of generosity on the part of the
financial institution (as so often happens in practice),
but rather as a basic right of such a client.
Compensation can flow through various channels and
can be triggered by various means. The easiest case is
where the client complains about a wrong action on
the part of the firm and is compensated immediately as
a consequence thereof. If the firm refuses to
compensate, the client can take his case to the
industry’s ombudsman who will reconsider the case. If
the client is still unhappy about the rulings of the
industry’s adjudicator, the case can be brought before
a court of law.
Since the late 1990s market conduct regulation has
been improved significantly in South Africa. Today,
banks have a strict code of market conduct; an effective
and independent redress mechanism for customers; and
an industry adjudicator (operative effectively since
early 2000). Similar developments are eventually
envisaged for the insurance industry, but as yet they
have not materialised. In the securities business, the
compensation of wronged investors ultimately flows
from the exchanges’ fidelity or guarantee funds. The
compensation is usually limited though. In the case of
banks, the adjudicator can demand compensation up to
R500 000, but the compensation of the long-term
insurance ombudsman is limited to R250 000. The
Guarantee Fund of the BESA limits payouts to a
maximum of R100 million for all clients of defaulting
members; the Guarantee Fund of the JSE compensates
to a maximum of R5 million per client, and the Fidelity
Fund of SAFEX limits itself to R1 million per client65.
One fundamental problem remaining in South Africa
is that not all market conduct is vested in one single
specialist regulator for all market-conduct issues.
Currently the Department of Trade and Industry, rather
than the National Treasury, deals with issues such as
the investor protection provisions of the Companies
65
In the case of SAFEX its clearing members accept full
responsibility for the credit risks of its clients.
183
Act, corporate governance standards and possible
claims arising from the Usury Act. Ensuring co-
ordination among the various government departments
has proven difficult in practice and is clearly not to the
advantage of the wronged consumer.
To support the intermediate goal of adequate
compensation schemes, the following regulatory
targets can be identified:
• Stipulate ombudsmen arrangements: This is one of
the most cost-efficient and effective ways to
compensate wronged investors.
• Stipulate fidelity fund arrangements: A necessary
arrangement if brokers are operating in an
individual capacity and are therefore relatively
thinly capitalised.
• Establish a bank deposit-insurance scheme:
Although not without inherent problems (mainly
conflicts of interest and moral hazard issues), these
schemes usually operate as compensation schemes
for small depositors only. In effect they only
replace implicit compensation contracts with an
explicit contract.
• Establish a single regulator for all market-conduct
rulings: Only by centralising the regulation of
market conduct activities can oversight and
responsibility be enhanced in this area. Better
compensation mechanisms will result from a better
organisational structure.
4. Conclusion
4.1 Summary
The dualistic underlying nature of the South African
economy is very evident in its financial sector. On the
one hand there is a highly sophisticated financial
industry serving the daily needs of inter alia
multinational companies, the government and wealthy
households, while on the other hand this same industry
is unable to assist in a meaningful way upcoming
small businesses and poorer households.
For a lower-middle-income country66 South Africa’s
66
Based on the World Bank’s classification.
184
financial industry is clearly one of its crown jewels. The
industry assists in a major way to bridge the national
savings gap by ensuring adequate capital inflows from
abroad. Any attempts to pluck this goose extensively
will affect its health, and in turn the international
investor confidence that is so crucial for supporting
sustainable economic growth in South Africa.
International competition forces the big banks to
focus on high-yielding business and stringent cost
controls (and thus the elimination of cross-
subsidising). However, international competition still
does not exclude the possibility of a lack of sufficient
competition in the domestic markets. To service the
financial needs of the small business sector and lower-
income households, the authorities may have to
consider a number of fundamental steps to increase
competitiveness in local markets. For example: the
deregulation of the commercial paper and corporate
bond markets; removal of the regulatory barriers
against foreign banks; opening the national payment
system to non-bank financial institutions; and the
creation of core banks. Likewise, the authorities could
increase the degree of competition in the local
insurance market. It could do so, for instance, by
allowing foreign insurers to sell their policies in South
Africa on a branch basis, rather than forcing these
insurers to establish local subsidiaries.67
When considering the long-term economic prospects
for South Africa in an Aids scenario, the regulatory
authorities cannot close their eyes to its socio-
economic impact in the next few years. The
consequential costs of Aids may badly affect the local
banking and insurance businesses. How badly is still
an open question, because this uncertainty cannot be
properly quantified with current value-at-risk models
(as there is simply no meaningful local data or back-
tracking possibilities). However, to cope with this
higher degree of uncertainty, the authorities may
consider decreasing the financial gearing of financial
67
In such a case South African insurance regulators would become
host regulators to such foreign insurers, implying that the local
authorities would have to be satisfied with the standards of the
home regulators.
Financial Regulation in South Africa: Chapter 7
institutions in general. The banks’ and securities firms’
capital ratios may have to be increased from 8 per cent
to 10 or even 12 per cent of risk-weighted assets.
Similarly, the insurance regulator may have to re-
evaluate the implied financial gearing of insurers.
South Africa’s current financial infrastructure is
quite good, but not so good that it fulfils all the
prudential principles set by the Basel Committee,
IOSCO and IAIS. Implementing more fully all these
international minimum standards (or principles) may
take a few more years. The Policy Board for Financial
Services and Regulation, the South African Reserve
Bank and the Financial Services Board are fully aware
of the work still to be done in this area. Likewise, the
King Commission has started its second report on
corporate governance in South Africa. The
Commission’s recommendations on how to harmonise
local governance issues with international minimum
standards are expected later in 2001.
The optimal regulatory architecture is a topic that
needs urgent attention in South Africa. The co-
operation and co-ordination among the various
domestic regulators and between home and host
regulators has to be investigated more carefully. In a
similar vein, co-ordination between the various markets
(both formal and OTC) in terms of their cross-market
risks needs to be addressed. Last but not least, the
regulatory authorities have to ensure that retail
investment funds are properly protected against abuse
and actuarially sound, which in turn involves close
interaction with other government departments. To
ensure that the authorities themselves operate
efficiently and effectively, consideration should also be
given to the establishment of a regulatory audit agency.
Particularly in a world likely to be increasingly
dominated by e-commerce, consumers have to be fully
aware that they operate in this area exclusively on a
caveat emptor basis. To ensure integrity, fairness and
competence in these e-markets, disclosure and
transparency are of crucial importance to consumers.
The authorities have to assist the consumer and the
financial press by benchmarking the flood of financial
information. Moreover, even if the decapping of
Financial Regulation in South Africa: Chapter 7
insurance commissions proves difficult in the medium
term, consumers have to be aware of these commission
payments (i.e. the plain disclosure of service fees).
Capped insurance commissions are not controlled
prices, but simply maximums. The authorities should
encourage price negotiations, competition and possibly
lower commissions.
In line with the recommendations of the Basel
Committee, the South African Reserve Bank has
established a Financial Stability Committee (and Unit)
that will closely investigate the interaction between
macroeconomic policy, macroprudential and
microprudential requirements. Of particular
importance will be the precise roles of the central bank
as lender of last resort, and its de facto role as forward-
coverer of last resort and guarantor of the payments
system. Much work still has to be done in this new
area. For instance, the involvement of the central bank
in financial stability policy may require a new look at
the traditional regime of fixed minimum capital
requirements for banks. To stabilise liquidity
conditions in the markets over the business cycle – and
thus avoid possible asset bubbles, property crashes and
the like – the monetary authorities may well have to
adjust the minimum capital ratios during different
stages of the business cycle.
Liquidity management may also involve fiscal policy;
as for instance the current transaction taxes levied on
securities trade undermine the competitiveness of the
local markets vis-à-vis overseas markets. In fact, the
interaction between monetary policy and financial
regulation is likely to become even closer in future,
particularly considering the outstanding issues of
exchange controls, lender-of-last-resort facilities,
banks’ exit policies, Structured Early Intervention and
Resolution regimes, and possibly cyclically adjusted
minimum capital standards that all impact in a major
way on the financial regulatory regime.
4.2 The way forward
All the above issues are incorporated into the targets
developed in Section 3. As these targets are intended to
address South African financial regulation for the 2000s
185
it may be necessary to make an early start in allocating
these targets to task forces for further investigation. For
example, one such task force could investigate those
targets that are associated with competition.68
All the targets identified in Section 3 are
summarised in Table 7.2.
68
This task force could conduct similar research to that of the
Cruickshank Commission in the UK.

Table 7.2: Summary of regulatory targets for the 2000s

Systemic stability
1. Competitive market infrastructure
• Establish a payments system open to all financial institutions
• Promote competitive trading, clearing and settlement systems
• Promote competitive listing requirements
• Stipulate minimum infrastructural standards
• Establish interrelated and competitive markets
• Establish regulatory neutrality towards foreign participants

2. Acceptable maturity and currency mismatches

• Promote accurate value-at-risk systems
• Promote the management of the forward currency book by the private sector
• Promote prudent debt-management systems in the public sector
3. Acceptable cross-market exposures
• Establish cross-market risk-management, clearing and settlement facilities
• Establish legally binding netting agreements between markets
4. Sufficient market liquidity
• Establish a financial stability unit at central bank
• Formalise the standby facilities of central bank
• Remove (tax) constraints on market turnover
• Promote foreign participation in local markets
5. Securities markets as an alternative to financial intermediation
• Remove constraints on commercial paper and corporate bond issues from the Banks Act
• Promote the engineering and implementation of an SMME bond instrument
6. Regulatory effectiveness, efficiency and economy
• Establish co-ordination agreements among domestic regulatory agencies
• Establish harmonisation agreements between home and host regulators
• Stipulate regulatory cost-benefit analysis
• Establish a regulatory audit agency
• Establish ratings of national regulatory agencies

186 Financial Regulation in South Africa: Chapter 7

 Table 7.2: Summary of regulatory targets for the 2000s (continued)
Institutional safety and soundness
7. Proper risk assessment
• Promote accurate value-at-risk systems
• Stipulate consolidated supervision
• Appoint specific non-executive board members to supervise risk-management and management
control systems
• Appoint accredited private rating agencies
• Promote unsecured subordinated debt as a rating tool

8. Proper financial institutional infrastructure and suitability standards

• Adhere to minimum accounting and audit standards
• Adhere to minimum capital standards
• Adhere to corporate governance standards
• Adhere to compliance standards
• Establish an infrastructure for the verification of firms’ risk and control systems
• Establish an industry register of doubtful and bad debts
• Stipulate suitability standards for directors and senior management
9. Global institutional competitiveness and competitive neutrality
• Abolish foreign exchange controls as soon as possible
• Adhere to international agreements on regulatory minimum standards
• Encourage a functional approach to regulation
• Encourage competitive neutrality between commerce and e-commerce

Financial Regulation in South Africa: Chapter 7 187

 Table 7.2: Summary of regulatory targets for the 2000s (continued)
Consumer protection
10. Integrity, fairness and competence
• Encourage a code of corporate governance
• Encourage a code of business conduct
• Establish a policy to reduce financial crime and money laundering
• Encourage effective compliance manuals
• Stipulate “fit and proper” standards for the compliance office
11. Adequate product/service competitiveness
• Remove constraints on competitive foreign products
• Remove regulatory exclusions granted to parastatals or public corporations
12. Transparency and disclosure
• Adhere to an international code of corporate governance
• Establish government-defined benchmarks for better consumer information
• Inform the financial press
13. Adequate access to retail financial services
• Establish core banks in retail trading sector
• Open the payments system to non-bank financial institutions
14. Protection of retail funds
• Establish a Structured Early Intervention and Resolution regime
• Stipulate acceptable operational risk-management systems
• Limit the use of retail investment funds as an instrument of social engineering
15. Retail compensation schemes
• Stipulate ombudsmen arrangements
• Stipulate fidelity fund arrangements
• Establish a bank deposit-insurance scheme
• Establish a single regulator for all market-conduct rulings

188 Financial Regulation in South Africa: Chapter 7

 INDEX
access to retail financial services, 22, 182 components and instruments of the regulatory regime, 31
accountability, 115 conduct of business regulation, 12
accountability of financial regulators, 153 conduct of business requirements, 55
accounting consolidation, 96 conduct of investment business, 55
accounting rules, 167 conflict-conciliatory principles, 42
adverse selection, 11, 16 connected lending, 87
agency diversification, 52 connected parties, 94
agents, 143 consolidated regulation, 95, 96
asset price collapses, 85 consolidated supervision, 93, 96
asymmetric information, 22 consumer confidence, 15
auction-driven markets, 127 consumer demand for regulation, 15
audit agency, regulatory, 69 consumer protection, 2, 11, 19, 25
audit rules, 167 competence, 21
automated-trading system, 131, 132 integrity and fairness, 21
autonomy, 95 protection of retail funds, 22
bank supervision, 103 retail compensation schemes, 22
core principles, 74 transparency and disclosure, 21
political dimension, 105 contagion across markets and countries, 85
bank-deposit insurance requirement, 58 contestability, 3, 4, 5
banks, 140 contestability and merger and acquisitions, 5
basic markets, 125 contract regulation, 27, 113
brokers, 142, 143 corporate bond market, 166
building blocks, 116 corporate governance, 36, 40, 67, 68, 153, 167
business conduct requirements, 55 and the regulator, 69
capital adequacy, 54, 112, 168 cost of regulation, 70
capital inflows, 85 credit rating
causes of financial crises, 84, 86 capital market assessment, 66
circuit breakers, 167 recognition of agencies, 65
clearing systems, 166 credit risk, 64
commercial paper, 160 cross-market exposures, 171
commercial paper market, 166 cross-market netting, 167
compensation scheme requirement, 57 cross-market risk management, 167
competence, 21 dealers, 143
competition, 20 deposit-insurance scheme, 110
competitive market infrastructure, 18 deregulation, 76, 78, 79, 81
financial intermediaries and securities markets, 91 deregulation and reregulation, 76
global institutional, 19 derivative markets, 124
neutrality, 19 direct and indirect costs of regulation, 70
competition and contestability, 4 discipline on and accountability of regulators, 37, 40, 69
competitive neutrality, 19, 168, 178 discipline on financial regulators, 153
complex group supervision, 97 disclosure. See transparency
complex groups, 97, 168 disclosure and advice, 46, 47
compliance, 30 diversification, 51, 52
and data examination requirements, 63 double gearing of capital, 94
culture, 30 dual capacity, 132
incentives, 62 dual-capacity trading rule, 133
non-compliance, 21 Dutch auction, 127

Financial Regulation in South Africa: Chapter

Index 7 189
economic regulation, 1 financial intermediation, 141, 173
economies of scale in monitoring, 13 financial market participants, 140, 144
e-exchanges, 167 accountability of regulators, 153
effective banking supervision, 74 banks, 140
effective regulation, 1 brokers, 142
efficient regulation, 1 corporate governance, 153
enforcement, 93 financial advisers, 142
English auction, 127 incentive contracts and structures, 152
enhanced lead regulation, 103 institutional investors, 140
Enterprise-wide Risk Management, 64 intervention and sanctions, 151
entry and standards constraints, 45, 146 investment firms, 140
entry barriers, 67 market monitoring and discipline, 152
entry requirements, 46 official monitoring and supervision, 151
entry standards, 46 OTC markets, 140
ethos of regulation, 81 regulated market, 143
exchange controls, 168 regulatory matrix, 147
exchange rate regimes, 85 regulatory regime, 144
execution, clearing and settlement functions, 138 rules and regulations, 146
exit policy, 110 traders, 140
exposures, cross-market, 18 financial markets, 118
external auditors role, 64 auction driven, 127
externalities, 12 basic markets, 125
failure, institutional. See financial crises defining, 118
financial advisers, 142 derivative markets, 124
financial conglomerates, 49 formalising OTC markets, 122
financial crises instruments traded, 123
asset price collapses, 85 order driven, 128
capital inflows, 85 OTC markets, 121
contagion, 85 primary markets, 126
exchange rate regimes, 85 quote driven, 128
financial liberalisation, 87 regulated markets, 121
incentives, 87 regulation, 126
liquidity, 86 regulatory matrix, 135
macroeconomic causes, 84 regulatory regime, 133
macroeconomic volatility, 85 secondary markets, 126
regulatory causes, 86 single/dual-capacity trading, 133
regulatory responses, 88 spot markets, 123
social and individual cost of bankruptcy, 13 trading systems, 129
financial distress. See financial crises financial press, 67, 99
financial engineering, 116 financial products and services, nature of, 14
financial fraud, 168 financial stability, 100, 101
financial infrastructure, 159, 161, 167 financial stability policy, 102, 168
financial innovation, 78 financing through securities markets, 91
financial institutions, 157, 160, 163 first price auction, 127
financial instruments, 116 fit and proper standards, 45
definition and nature, 116 for individuals, 45
issue standards, 48 suitable directors and management, 19
regulatory matrix, 119 floor-trading system, 130
regulatory regime, 116 formal market, 134

190 Financial Regulation in South Africa: Chapter

Index 7
functional activity constraints, 50, 146 jurisdiction, 53
functional activity restrictions, 50 jurisdictional constraints, 52, 148
functional approach, 7 lack of market liquidity, 86
functional regulation, 103 lead regulation, 103
generic types of regulation, 12 lender of last resort, 107
global financial distress. See financial crises lending booms, 85
global institutional competitiveness, 19 lifeboat facility, 110
governance and the regulator, 69 liquidity management, 167
gridlock, 11, 16 liquidity risk, 64, 98
harmonising regulatory arrangements, 71 listed financial instruments, 138
hazards in regulation, 17 macroeconomic volatility, 85
highly geared off-shore institutions, 98 market depth and liquidity, 18
home regulatory arrangements, 168 market discipline, 34, 91
host regulatory arrangements, 168 assessment, 35
implicit contracts, 17 market imperfections and failures, 12
incentive contracts and structures, 33, 39, 61, 152 market infrastructure, 169
incentives, 61, 114 market liquidity, 172
incentives for management, 62 market maker market, 128
incentives for owners, 61 market makers, 143
incentives to contain systemic and business risks, 63 market monitoring and discipline, 34, 39, 64, 152, 168
incentives to create a sound compliance culture, 62 market regulators, 136
infrastructure market risk, 64
financial institutional infrastructure, 19 market specialists, 143
financial system, 88 maturity and currency mismatches, 18, 86, 170
international standards, 90 merger and acquisitions, 5
institutional approach, 7 methods of regulation, 81
institutional competitiveness, 178 minimum standards, 46, 48
institutional failure. See financial crises monetary stability, 100
institutional infrastructure, 178 monitoring
institutional investors, 140 capabilities, 92
institutional safety and soundness, 2, 18, 24 economies of scale, 13
instruments of regulation, 37 moral hazard, 11, 16
accountability of regulators, 40 nature of financial products and services, 14
corporate governance, 40 non-compliance, 21
incentive contracts and structures, 39 novation, 72, 117, 137
intervention and sanctions, 39 objectives of regulation, 2, 18
market monitoring and discipline, 39 objectives, intermediate goals and targets of
official monitoring and supervision, 38 regulation, 17
rules and regulations, 38 official monitoring and supervision, 32, 38, 59, 151
integrity, fairness and competence, 21, 179 offshore institutions, 98
intermediate goals of regulation, 18, 23, 42 operational constraints, 53, 148
intermediation operational risk, 64
competition with securities markets, 91 order book driven markets, 128
securities markets as an alternative, 18, 173 order driven market system, 130
international regulatory standards, 90 order driven markets, 128
international standards, 90 over the counter (OTC) market, 121, 134
intervention and sanctions, 32, 39, 60, 151 own service diversification, 51
investment firms, 140 ownership constraints, 49, 146
issuance standards, 48 philosophy of regulation, 1

Financial Regulation in South Africa: Chapter

Index 7 191
platforms financial instruments, 116
execution, clearing and settlement functions, 138 financial market participants, 144
pricing constraints, 53, 148 formal markets, 134
primary securities markets, 126 incentive contracts and structures, 33, 61
principal traders, 143 intervention and sanctions, 32, 60
principles of regulation, 3 market discipline, 91
conflict-conciliatory, 6 market monitoring and discipline, 34, 64
efficiency related, 3 official monitoring and supervision, 32, 59
general, 8 OTC markets, 134
regulatory structure, 7 rules and regulations, 45. See rules and regulations
stability related, 5 structure of financial markets, 133
product competitiveness, 180 regulatory regime in South Africa, 154
protection of retail funds, 182 alternative to intermediation, 173
prudential regulation, 12, 54 compensation schemes, 183
pyramid holding companies, 50 competitive neutrality, 178
quote driven dealership market, 128 cross-market exposures, 171
quote driven markets, 128, 129 disclosure, 180
rating agencies, 65 in 1980s, 157
ratings, 168 in 1990s, 159
rationale for regulation, 11 in 2000s, 162
regulated market, 121 fit and proper standards, 178
regulatory accountability, 168 global competitiveness, 178
regulatory arbitrage, 94 integrity, fairness and competence, 179
regulatory architecture market infrastructure, 169
basic function authorities, 137 market liquidity, 172
market regulators, 136 maturity and currency mismatches, 170
single authority per basic market, 137 product and service competitiveness, 180
South Africa, 139 regulatory effectiveness, 174
specialised authorities, 137 retail funds protection, 182
regulatory audit agency, 69 risk assessment, 176
regulatory co-ordination, 71 service access, 181
regulatory effectiveness, efficiency and economy, 18, 174 targets and gaps, 169
regulatory gaps, 169 the way forward, 185
regulatory instruments. See instruments of regulation regulatory regime paradigm, 113
regulatory matrix, 42 regulatory strategy, 26, 28, 41
alignment of instruments to goals, 43 strategy matrix, 42
financial instruments, 119 regulatory targets, 22, 169, 186
financial market participants, 147 remote trading, 167
financial markets, 135 reregulation, 76, 80
impact of deregulation, 77 reregulation and self-regulation, 80
regulatory objectives, 2, 18 retail compensation schemes, 183
intermediate goals of regulation, 18 risk
regulatory philosophy, 1 incentives to contain systemic and business risks, 63
regulatory principles, 3 risk assessment, 19, 176
regulatory regime, 26, 42, 154 rules and regulations, 31, 38, 45, 146
accountability of regulators, 37, 69 entry and standards constraints, 45
alternative approaches, 26 entry and standards requirements, 31
components and instruments, 31 functional activity constraints, 31, 50
corporate governance, 36, 67 jurisdictional constraints, 31, 53

192 Financial Regulation in South Africa: Chapter

Index 7
 operational constraints, 31, 53
ownership constraints, 31, 49
pricing constraints, 31, 53
safety net arrangements, 106, 168
deposit-insurance scheme, 110
lender of last resort, 107
lifeboat, 110
sanctions, 91
screen-trading system, 131
secondary securities markets, 126
second price auction, 127
securities markets, 91, 92, 158, 160, 164, 173
Securities Regulation Panel, 161
securitised asset markets, 166
self-regulation, 80
self-regulatory organisations (SROs), 80
separate regulation, 95, 96
settlement systems, 166
single capacity, 132
single regulatory authority, 73, 137
single-capacity trading requirement, 56
single-capacity trading rule, 133
social and individual cost of bankruptcy, 13
socio-economic environment, 155
solo plus, 96
solo plus regulation, 96
South African financial system, 116
specialist regulatory authorities, 137
spot markets, 123
Financial Regulation in South Africa: Chapter
Index 7
stability, 2, 18, 23
and central banks, 101
externalities, 12
financial, 100
monetary, 100
stock adjustment, 79
strategic framework for regulation, 41
goals and operational targets, 41
objectives, 41
regulatory regime, 41
strategy matrix, 42
structure of financial markets, 133
structure of regulation, 81, 136
Structured Early Intervention and Resolution
arrangements, 60
suitability standards, 178
super-regulatory agency, 168
supervision capabilities, 92
systemic bank restructuring, 111
systemic stability. See stability
target-instrument approach, 41, 42
targets of regulation, 22, 186
tâtonnement auction, 127
telephone/screen-quotation trading system, 130
traders, 140
trading requirements, 56
trading systems, 129
transparency, 22, 97, 114, 167, 180
value-at-risk systems, 168
warehousing securities, 140
193